The Seven

Deadly Innocent Frauds

of Economic Policy

By

Warren
Mosler

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TABLE OF
CONTENTS

Introduction

Foreword

Prologue

OVERVIEW

Introduction

Part I: The
Seven Deadly Innocent Frauds

Deadly
Innocent Fraud #1:

How are you
going to pay for it???!!!

How does the
Federal Government Tax?

How the
Federal Government Spends

Federal
Government checks don’t bounce.

Why the
Federal Government Taxes

Deadly
Innocent Fraud #2:

Federal
Government Taxing and Spending Does Influence Distribution

So How Do We
Pay Off China?

Deadly
Innocent Fraud #3: Federal Government budget deficits take away savings.

Lawrence
Summers

Al Gore

Robert Rubin

Professor
Wynne Godley

Deadly
Innocent Fraud #4: Social Security is broken.

Steve Moore

Deadly
Innocent Fraud #5: The trade deficit is an unsustainable imbalance that takes
away jobs and output.

Deadly
Innocent Fraud #6: We need savings to provide the funds for investment.

Professor
Basil Moore

Deadly
Innocent Fraud #7: It’s a bad thing that higher deficits today mean higher
taxes tomorrow.

Part II: The
Age of Discovery

Wall Street

Italian
Epiphany

Part III:
Public Purpose

To address
the current financial crisis and economic collapse, I recommend a number of
proposals in the pages ahead.

A Payroll
Tax Holiday

Revenue
sharing

National
Service Jobs

Universal
Health Care Coverage

Proposals
for the Monetary System

Strategic
Stockpiles

How We Can
All Benefit from the Trade Deficit

Industries
with Strategic Purpose

Optimum
Deficit

Interest
Rates and Monetary Policy

The Role of
Government Securities

Children as
an Investment Rather than an Expense

Public
Purpose

Inflation!

Inflation
vs. Price Increases

PowerPoint
Presentation Made to Hedge Fund Managers.

Footnotes

Other
Recommended Books

About the
Author

Introduction

The
author has been called "one the brightest minds in finance" by CNBC
in 2010.

Nicknamed
by many as the “Morpheus of Modern Money”, the author explains
that prosperity is around the corner for the nation and everyone in it, not
just the select few, but only if the public understands what is money, how
monetary policy operates and how it can be used to achieve a public purpose
without the need to raise taxes nor increase government borrowing.

SO
A WARNING:  Are you ready to take the Red
Pill to understand what is money, how it operates
and to learn how to legitimately question the many choices made by the
President and Congress including sequestration, budget cuts and the failure to
create full employment?

Are
you willing to take a trip down the rabbit hole to find out how much of what
you were taught about economics in college and almost everything you read in
media about monetary policy is wrong? The rabbit hole is very deep. It
will definitely challenge how you think about economics, monetary policy and
how we, as a nation, are failing at producing our real full potential.

As John
Kenneth Galbraith once said,

The
study of money, above all other fields in economics, is one in which complexity
is used to disguise truth or to evade truth, not to reveal it. The process by
which banks create money is so simple the mind is repelled. With something so
important, a deeper mystery seems only decent.

Your
trip down the rabbit hole starts when you read the newspapers to find that the
President and Congress are talking about the need to cut the deficit because it
impacts our ability to save. They argue that the deficit takes money from the
economy and thus restricts business access to capital.

But
as you start going down the rabbit hole, you find that:

Government deficits do not take away from savings. The simple
fact is that deficits add to savings to the penny. The total $U.S. government
deficit exactly EQUALS the total net increase in private sector holdings.
In fact, it’s the trillion dollar deficit that has added trillions to our
savings.

Your
head is spinning as you try to figure this out. DEFICITS
= SAVINGS. You begin to wonder if this is the magic formula for finance
just like Einstein’s E=MC^2 is for physics. While trying to
figure out why you always thought the opposite, you hear on TV some politicians
arguing for sequestration as well as fighting among each other with regards to
what government programs they are going to slash spending for in order to
balance the budget.

But
as you go further down the rabbit hole, you find out that:

The government is not revenue constrained – it does not need to
tax nor borrow in order to spend. In fact, as a simple point of logic, from the
inception, the government must spend first before it can tax or borrow. Where
else can the dollars come from if they are not counterfeit?

Your
brain starts to become numb. The government does not need to tax nor borrow?
You find this very difficult to comprehend. It makes no sense to you. It is not
what you have been taught. It flies in the face of what you understand to be
capitalism. There is pressure building up behind your eyes and you feel a
headache is on the way.  A Wall Street friend then informs you that we are
very selfish because the deficits (our deficits) are the result
of our selfish lifestyle needs and, as a result, we are
leaving our debt burden to our children and
grandchildren and our selfish infatuation with entitlements
will hinder their future lifestyles and well-being.

But
as you go stagger down the rabbit hole, you find out that:

Our children and grandchildren will get to consume what they
produce. It has nothing to do with the deficit.

You
had initially thought that your friend had made a valid argument, but now you
are confused. You then access the internet and find that the hot trending story
of the day is about social security and how social security will make the
nation bankrupt if it is not fixed.

The
rabbit hole initially had a steady decline, but it is now becoming very steep.
As your pace accelerates you find that:

Social Security is not broken – federal checks never bounce and
the government cannot be forced to go bankrupt. Congress, never the markets,
decides what they want to do.

You
begin to wonder if everything you hear and read is simply propaganda. You
remember being told that the government was not experienced in managing money
and thus social security would be best served being privatized.

The
rabbit hole is becoming more intense – information is flowing everywhere and
you find deciphering it is simple. When you decipher the information, you find
out that:

Privatization of Social Security is simply a wheel spin. Nothing
changes the macro-economy. Savings and investment stay exactly the same to the
penny! The push for privatization is simply a means to generate more profits
for the private sector.

You
then hear your father shout in your ear that if American families ran their
households like the federal government, we would all be bankrupt.

You
now feel as if feel you are freefalling down the rabbit hole, but while
everything is swirling around you see that:.

The government is
the issuer of the dollar and can mandate that people pay taxes with its
dollars.  Households can’t and so households can run out of dollars.
However, the U.S. can never run out of dollars. Whatever spending Congress
decides to appropriate, it gets paid for with dollars that Congress creates.
The only relevant question is what are the real effects on the economy, not on how many
dollars Congress has to spend.

All
of a sudden you begin to feel a little light headed as endorphins rush through
your body. You feel great because you are discovering the truth.  Creating money by issuing debt is a political choice that
simply benefits a privileged class. The objective, indeed the responsibility,
of money creation is to create all the money needed to operate the economy and
to remove any money in excess of what is needed. With some of the 7
Deadly Innocent Frauds explained, you can now see the possibilities and
potential for government by making monetary policy work for a public purpose
and generating societal prosperity for all.

This
book was originally published in 2010 and was principally targeted to the
general public.  This republication adds a PowerPoint presentation that
the author made to hedge funds and investment banks in 2010 on the issues
raised in this book. Those interested in the underlying economic dynamics for
this book can find it in Soft Currency Economics.

The book advances a large
number of economic proposals including making banks a public utility. The Obama
administration did partially and temporarily implement one of author's
proposals - a payroll tax cut. However the payroll tax was reinstituted in
early 2013. The author believes that this together with shrinkage in the deficit
could have a detrimental effect on the economy. The author still favors the
total elimination of the payroll tax for both companies and employees. Yes, you
will ask what will happen to social security when there is no money in the
government kitty to make payments when payments are
due. Read the book and you will find the answer.

.

Russ Huntley - editor

Foreword

Warren Mosler is a rare bird: a
self-taught economist who is not a crank; a successful investor who is not a
blowhard; a businessperson with a talent for teaching; a financier with a true
commitment to the public good.

We have co-authored testimony and the
occasional article, and I attest firmly that his contributions to those efforts
exceeded mine.

Many economists value complexity for
its own sake. A glance at any modern economics journal confirms this. A truly
incomprehensible argument can bring a lot of prestige!

The problem, though, is that when an
argument appears incomprehensible, that often means the person making it
doesn’t understand it either. (I was just at a meeting of European central bankers
and international monetary economists in Helsinki, Finland. After one paper, I
asked a very distinguished economist from Sweden how many people he thought had
followed the math. He said, “Zero.”

Warren’s gift is transparent lucidity.
He thinks things through as simply as he can. (And he puts a lot of work into
this - true simplicity is hard.) He favors the familiar metaphor, and the
homely example. You can explain his reasoning to most children (at least to
mine), to any college student and to any player in the financial markets. Only
economists, with their powerful loyalty to fixed ideas, have trouble with it.
Politicians, of course, often do understand, but rarely feel free to speak
their own minds.

Now comes Warren Mosler with a small
book, setting out his reasoning on seven key issues. These relate to government
deficits and debt, to the relation between public deficits and private savings,
to that between savings and investment, to Social Security and to the trade
deficit. Warren calls them “Seven Deadly Innocent Frauds” - taking up a phrase
coined by my father as the title of his last book. Galbraith-the-elder would
have been pleased.

The common thread tying these themes
together is simplicity itself. It’s that modern money is a spreadsheet! It works
by computer! When government spends or lends, it does so by adding numbers to private
bank accounts. When it taxes, it marks those same accounts down. When it
borrows, it shifts funds from a demand deposit (called a reserve account) to
savings (called a securities account). And that for practical purposes is all
there is. The money government spends doesn’t come from anywhere, and it doesn’t
cost anything to produce.

The government therefore cannot run
out. Money is created by government spending (or by bank loans, which create
deposits). Taxes serve to make us want that money - we need it in order to pay
the taxes. And they help regulate total spending, so that we don’t have more
total spending than we have goods available at current prices - something that
would force up prices and cause inflation.  But taxes aren’t needed in advance
of spending - and could hardly be, since before the government spends there is
no money to tax.

A government borrowing in its own
currency need never default on its debts; paying them is simply a matter of
adding the interest to the bank accounts of the bond holders. A government can
only decide to default – an act of financial suicide – or (in the case of a
government borrowing in a currency it doesn’t control) be forced to default by
its bankers.

But a U.S. bank will always cash a
check issued by the US Government, whatever happens.

Nor is the public debt a burden on the
future. How could it be? Everything produced in the future will be consumed in
the future. How much will be produced depends on how productive the economy is
at that time. This has nothing to do with the public debt today; a higher
public debt today does not reduce future production - and if it motivates wise use
of resources today, it may increase the productivity of the economy in the
future.

Public deficits increase financial
private savings - as a matter of accounting, dollar for dollar. Imports are a
benefit, exports a cost. We do not borrow from China to finance our
consumption: the borrowing that finances an import from China is done by a U.S.
consumer at a U.S. bank. Social Security privatization would just reshuffle the
ownership of stocks and bonds in the economy – transferring risky assets to
seniors and safer ones to the wealthy – without having any other economic
effects. The Federal Reserve sets interest rates where it wants.

All these are among the simple
principles set out in this small book. Also included here are an engaging
account of the education of a financier and an action program for saving the American
economy from the crisis of high unemployment.

Warren would do this by suspending the
payroll tax – giving every working American a raise of over 8 percent, after
tax; by a per capita grant to state and local governments, to cure their fiscal
crises; and by a public employment program offering a job at a modest wage to
anyone who wanted one. This would eliminate the dangerous forms of unemployment
and allow us to put our young people, especially, to useful work.

All in all, this book is an engaging
and highly instructive read - highly recommended.

James K. Galbraith

The University of Texas at
Austin

June 12, 2010

Prologue

The term “innocent fraud” was
introduced by Professor John Kenneth Galbraith in his last book, The Economics
of Innocent Fraud, which he wrote at the age of ninety-four in 2004, just two
years before he died. Professor Galbraith coined the term to describe a variety
of incorrect assumptions embraced by mainstream economists, the media, and most
of all, politicians.

The presumption of innocence, yet
another example of Galbraith’s elegant and biting wit, implies those
perpetuating the fraud are not only wrong, but also not clever enough to understand
what they are actually doing. And any claim of prior understanding becomes an admission
of deliberate fraud - an unthinkable self-incrimination.

Galbraith’s economic views gained a
wide audience during the 1950s and 1960s, with his best-selling books The
Affluent Society, and The
New Industrial State. He was well connected to both the Kennedy and Johnson
Administrations, serving as the United States Ambassador to India from 1961 until
1963, when he returned to his post as Harvard’s most renowned Professor of
Economics.

Galbraith was largely a Keynesian who
believed that only fiscal policy can restore “spending power.” Fiscal policy is
what economists call tax cuts and spending increases, and spending in general
is what they call aggregate demand.

Galbraith’s academic antagonist,
Milton Friedman, led another school of thought known as the “monetarists.” The monetarists
believe the federal government should always keep the budget in balance and use
what they called “monetary policy” to regulate the economy. Initially that
meant keeping the “money supply” growing slowly and steadily to control
inflation, and letting the economy do what it may. However they never could
come up with a measure of money supply that did the trick nor could the Federal
Reserve ever find a way to actually control the measures of money they
experimented with.

Paul Volcker was the last Fed Chairman
to attempt to directly control the money supply. After a prolonged period of actions
that merely demonstrated what most central bankers had known for a very long
time - that there was no such thing as controlling the money supply - Volcker
abandoned the effort.

Monetary policy was quickly redefined
as a policy of using interest rates as the instrument of monetary policy rather
than any measures of the quantity of money. And “inflation expectations” moved
to the top of the list as the cause of inflation, as the money supply no longer
played an active role. Interestingly, “money” doesn’t appear anywhere in the latest
monetarist mathematical models that advocate the use of interest rates to
regulate the economy.

Whenever there are severe economic
slumps, politicians need results - in the form of more jobs - to stay in
office. First they watch as the Federal Reserve cuts interest rates, waiting
patiently for the low rates to somehow “kick in.”

Unfortunately, interest rates never to
seem to “kick in.” Then, as rising unemployment threatens the re-election of members
of Congress and the President, the politicians turn to Keynesian policies of
tax cuts and spending increases. These policies are implemented over the
intense objections and dire predictions of the majority of central bankers and
mainstream economists.

It was Richard Nixon who famously
declared during the double dip economic slump of 1973, “We are all Keynesians
now.”

Despite Nixon’s statement, Galbraith’s
Keynesian views lost out to the monetarists when the “Great Inflation” of the 1970s
sent shock waves through the American psyche. Public policy turned to the
Federal Reserve and its manipulation of interest rates as the most effective
way to deal with what was coined “stagflation” - the combination of a stagnant
economy and high inflation.

I entered banking in 1973 with a job
collecting delinquent loans at the Savings Bank of Manchester in my home town
of Manchester, Connecticut. I was the bank’s portfolio manager by 1975, which
led to Wall St. in 1976, where I worked on the trading floor until 1978. Then I
was hired by William Blair and Company in Chicago to add fixed income arbitrage
to their corporate bond department. It was from there that I started my own
fund in 1982. I saw the “great inflation” as cost-push phenomena driven by
OPEC’s pricing power. It had every appearance of a cartel setting ever-higher
prices which caused the great inflation, and a simple supply response that broke
it. As OPEC raised the nominal price of crude oil from $2 per barrel in the
early 1970’s to a peak of about $40 per barrel approximately 10 years later, I
could see two possible outcomes. The first was for it to somehow be kept to a
relative value story, where U.S. inflation remained fairly low and paying more
for oil and gasoline simply meant less demand and weaker prices for most everything
else, with wages and salaries staying relatively constant. This would have
meant a drastic reduction, in real terms, of trade and standard of living, and an
even larger increase in the real terms of trade and standard of living for the
oil exporters.

The second outcome, which is what
happened, was for a general inflation to ensue, so while OPEC did get higher prices
for its oil, they also had to pay higher prices for what they wanted to buy,
leaving real terms of trade not all that different after the price of oil finally
settled between $10 and $5 per barrel where it remained for over a decade. And
from where I sat, I didn’t see any deflationary consequences from the “tight”
monetary policy. Instead, it was the deregulation of natural gas in 1978 that
allowed natural gas prices to rise, and therefore, natural gas wells to be
uncapped. U.S. electric utility companies then switched fuels from high-priced
oil to what was still lower-priced natural gas. OPEC reacted to this supply
response by rapidly cutting production in an attempt to keep prices from
falling below $30 per oil barrel. Production was cut by over 15 million barrels
a day, but it wasn’t enough, and they drowned in the sea of excess world oil
production as electric utilities continued to move to other fuels.

This book is divided into three
sections. Part one immediately reveals the seven “innocent frauds” that I
submit are the most imbedded obstacles to national prosperity.

They are presented in a manner that
does not require any prior knowledge or understanding of the monetary system, economics,
or accounting. The first three concern the federal government’s budget deficit,
the fourth addresses Social Security, the fifth international trade, the sixth savings
and investment, and the seventh returns to the federal budget deficit. This
last chapter is the core message; its purpose is to promote a universal
understanding of these critical issues facing our nation.

Part two is the evolution of my awareness
of these seven deadly innocent frauds during my more-than-three decades of experience
in the world of finance.

In Part three, I apply the knowledge
of the seven deadly innocent frauds to the leading issues of our day.

In Part four, I set forth a specific
action plan for our country to realize our economic potential and restore the
American dream.

Warren Mosler - April 15, 2010

OVERVIEW

Seven Deadly Innocent Frauds of Economic Policy:

- The government must raise
funds through taxation or borrowing in order to spend. In other words,
government spending is limited by its ability to tax or borrow.

- With government deficits, we
are leaving our debt burden to our children.

- Government budget deficits
take away savings.

- Social Security is broken.

- The trade deficit is an
unsustainable imbalance that takes away jobs and output.

- We need savings to provide
the funds for investment.

- It’s a bad thing that
higher deficits today mean higher taxes
tomorrow.

Introduction

This book’s purpose is to promote the
restoration of American prosperity. It is my contention that the seven deadly
innocent frauds of economic policy are all that is standing between today’s
economic mess and the full restoration of American prosperity.

As of the publication of this book, I
am campaigning for the office of U.S. Senator from my home state of
Connecticut, solely as a matter of conscience. I am running to promote my
national agenda to restore American prosperity with the following three
proposals.

The first is what’s called a “full
payroll tax holiday” whereby the U.S. Treasury stops taking some $20 billion EACH
WEEK from people working for a living and instead, makes all FICA payments for
both employees and employers.

The average American couple earning a
combined $100,000 per year will see their take-home pay go up by over $650 PER MONTH
which will help them meet their mortgage payments and stay in their homes, which
would also end the financial crisis. Additionally, the extra take-home pay
would help everyone pay their bills and go shopping, as Americans return to what
used to be our normal way of life.

My second proposal is for the federal
government to distribute $500 per capita of revenue sharing to the state governments,
with no strings attached, to tide them over and help them sustain their
essential services. The spending power and millions of jobs funded by people’s
spending from the extra take-home pay from the payroll-tax holiday restores economic
activity, and the States’ revenues would return to where they were before the
crisis.

My third proposal calls for a
restoration of American prosperity through a federally-funded $8/hr. job for
anyone willing and able to work. The primary purpose of this program is to
provide a transition from unemployment to private-sector employment. A
payroll-tax holiday and the state revenue sharing would bring an immediate
flurry of economic activity, with private-sector employers quickly seeking to
hire millions of additional workers to meet growing demand for their products.

Unfortunately, past recessions have
shown that businesses are reluctant to hire those who have been unemployed,
with the long-term unemployed being the least attractive. Transitional
employment also would draw these people into the labor force, giving them a
chance to demonstrate what they can do, and show that they are responsible and
can get to work on time.

This includes giving the opportunity
of work to many of those who have a harder time finding private-sector
employment, including high-risk teenagers, people getting out of prison, the disabled
and older as well as middle-aged people who have lost their jobs and exhausted
their unemployment benefits.

While this program would involve the
lowest expenditure of my three proposals, it is equally important as it helps
smooth and optimize the transition to private-sector employment as the economy
grows.

So, how am I uniquely qualified to be
promoting these proposals? My confidence comes from 40 years’ experience in the
financial and economic realm. I would venture that I’m perhaps the only person
who can answer the question: “How are you going to pay for it?” My book takes
on this issue and encourages the return of economics study to the operational realities
of our monetary system.

Part I: The Seven Deadly
Innocent Frauds

Deadly Innocent Fraud #1:

The federal government
must raise funds through taxation or borrowing in order to spend. In other
words, government spending is limited by its ability to tax or borrow.

FACT: FEDERAL GOVERNMENT SPENDING IS
IN NO CASE OPERATIONALLY CONSTRAINED BY REVENUES, MEANING THAT THERE IS NO
“SOLVENCY RISK.” IN OTHER WORDS, THE FEDERAL GOVERNMENT CAN ALWAYS MAKE ANY AND
ALL PAYMENTS IN ITS OWN CURRENCY, NO MATTER HOW LARGE THE DEFICIT IS, OR HOW
FEW TAXES IT COLLECTS.

Ask any congressman (as I have many
times) or private citizen how it all works, and he or she will tell you
emphatically that: “…the government has to either tax or borrow to get the funds
to spend, just like any household has to somehow get the money it needs to
spend.” And from this comes the inevitable question about healthcare, defense,
social security, and any and all government spending:

How are you going to pay
for it???!!!

This is the killer question, the one
no one gets right, and getting the answer to this question right is the core of
the public purpose behind writing this book.

In the next few moments of reading, it
will all be revealed to you with no theory and no philosophy- just a few hard
cold facts. I answer this question by first looking at exactly how government
taxes, followed by how government spends.

How does the Federal
Government Tax?

Let’s start by looking at what happens
if you pay your taxes by writing a check. When the U.S. government gets your check,
and it’s deposited and “clears,” all the government does is change the number
in your checking account “downward” as they subtract the amount of your check
from your bank balance. Does the government actually get anything real to give
to someone else? No, it’s not like there’s a gold coin to spend. You can
actually see this happen with online banking - watch the balance in your bank
account on your computer screen. Suppose the balance in your account is $5,000
and you write a check to the government for $2,000. When that checks clears
(gets processed), what happens? The 5 turns into a 3 and your new balance is
now down to $3,000. All before your very eyes! The government didn’t actually
“get” anything to give to someone else. No gold coin dropped into a bucket at
the Fed.

They just changed numbers in bank
accounts - nothing “went” anywhere.

And what happens if you were to go to
your local IRS office to pay your taxes with actual cash? First, you would hand
over your pile of currency to the person on duty as payment. Next, he’d count it;
give you a receipt and, hopefully, a thank you for helping to pay for social
security, interest on the national debt, and the Iraq war. Then, after you, the
tax payer, left the room, he’d take that hard-earned cash you just forked over
and throw it in a shredder.

Yes, it gets thrown away.
Destroyed! Why? There’s no further use for it. Just like a ticket to the Super
Bowl. After you enter the stadium and hand the attendant a ticket that was worth
maybe $1000, he tears it up and discards it. In fact, you can actually buy
shredded money from the U.S. Treasury.

So if the government throws away your
cash after collecting it, how does that cash pay for anything, like Social Security
and the rest of the government’s spending? It doesn’t.

Can you now see why it makes no sense
at all to think that the government has to get money by taxing in order to
spend? In no case does it actually “get” anything that it subsequently “uses.”
So if the government doesn’t actually get anything when it taxes, how and what
does it spend?

How the Federal
Government Spends

Imagine you are expecting your $2,000
Social Security payment to hit your bank account, which already has $3,000 in
it. If you are watching your account on the computer screen, you can see how government
spends without having anything to spend. Presto! Suddenly your account
statement that read $3,000 now reads $5,000. What did the government do to give
you that money? It simply changed the number in your bank account from 3,000 to
5,000. It didn’t take a gold coin and hammer it into a computer. All it did was
change a number in your bank account by making data entries on its own
spreadsheet, which is linked to other spreadsheets in the banking system.
Government spending is all done by data entry on its own spreadsheet called
“The U.S. dollar monetary system.”

Here is a quote from the good Federal
Reserve Bank Chairman, Ben Bernanke, on 60 Minutes for support:

SCOTT
PELLEY: Is that tax money that the Fed
is spending?

CHAIRMAN BERNANKE: It’s not tax money. The banks have accounts
with the Fed, much the same way that you have an account in a commercial bank.
So, to lend to a bank, we simply use the computer to mark up the size of the
account that they have with the Fed.

The Chairman of the Federal Reserve
Bank is telling us in plain English that they give out money (spend and lend)
simply by changing numbers in bank accounts. There is no such thing as having
to “get” taxes (or borrow) to make a spreadsheet entry that we call “government
spending.” Computer data doesn’t come from anywhere. Everyone knows that!

Where else do we see this happen? Your
team kicks a field goal and on the scoreboard, the score changes from, say, 7 points
to 10 points. Does anyone wonder where the stadium got those three points? Of course
not! Or you knock down 5 pins at the bowling alley and your score goes from 10
to 15.

Do you worry about where the bowling
alley got those points? Do you think all bowling alleys and football stadiums
should have a ‘reserve of points’ in a “lock box” to make sure you can get the
points you have scored? Of course not! And if the bowling alley discovers you “foot
faulted” and lowers your score back down by 5 points, does the bowling alley
now have more score to give out? Of course not!

We all know how data entry works, but
somehow this has gotten turned upside down and backwards by our politicians, media,
and, most all, the prominent mainstream economists.

Just keep this in mind as a starting
point:  The federal government doesn’t ever “have” or “not have” any dollars.

It’s just like the stadium, which
doesn’t “have” or “not have” a hoard of points to give out. When it comes to
the dollar, our government, working through its Federal agencies, the Federal
Reserve Bank and the U.S. Treasury Department, is the score keeper. (And it
also makes the rules!)

You now have the operational answer to
the question: “How are we going to pay for it?” And the answer is: the same way
government pays for anything, it changes the numbers in our bank accounts.

The federal government isn’t going to
“run out of money,” as our President has mistakenly repeated. There is no such thing.
Nor is it dependent on “getting” dollars from China or anywhere else. All it
takes for the government to spend is for it to change the numbers up in bank
accounts at its own bank, the Federal Reserve Bank. There is no numerical limit
to how much money our government can spend, whenever it wants to spend. (This
includes making interest payments, as well as Social Security and Medicare payments.)
It encompasses all government payments made in dollars to anyone.

This is not to say
that excess government spending won’t possibly cause prices to go up (which is
inflation).

But it is to say that the government
can’t go broke and can’t be bankrupt. There is simply no such thing. (1)

So why does no one in government seem
to get it?

Why does the Ways and Means Committee
in Congress worry about “how we are going to pay for it?” It could be that they
believe the popular notion that the federal government, just like any
household, must somehow first “get” money to be able to spend it. Yes, they
have heard that it’s different for a government, but they don’t quite believe
it, and there’s never a convincing explanation that makes sense to them.

What they all seem to miss is the
difference between spending your own currency that only you create, and
spending a currency someone else creates. To properly use this common federal
government/household analogy in a meaningful way, we next look at an example of
a “currency” created by a household.

The story begins with parents creating
coupons they then use to pay their children for doing various household chores.
Additionally, to “drive the model,” the parents require the children to pay
them a tax of 10 coupons a week to avoid punishment. This closely replicates
taxation in the real economy, where we have to pay our taxes or face penalties.

The coupons are now the new household
currency. Think of the parents as “spending” these coupons to purchase
“services” (chores) from their children. With this new household currency, the
parents, like the federal government, are now the issuer of their own currency.
And now you can see how a household with its own currency is indeed very much
like a government with its own currency.

Let’s begin by asking some questions
about how this new household currency works. Do the parents have to somehow get
coupons from their children before they can pay their coupons to their children
to do chores? Of course not! In fact, the parents must first spend their
coupons by paying their children to do household chores, to be able to collect
the payment of 10 coupons a week from their children. How else can the children
get the coupons they owe to their parents?

Likewise, in the real economy, the
federal government, just like this household with its own coupons, doesn’t have
to get the dollars it spends from taxing or borrowing, or anywhere else, to be
able to spend them. With modern technology, the federal government doesn’t even
have to print the dollars it spends the way the parents print their own
coupons.

Remember, the federal government
itself neither has nor doesn’t have dollars, any more than the bowling alley
ever has a box of points. When it comes to the dollar, our federal government is
the scorekeeper. And how many coupons do the parents have in the parent/child
coupon story? It doesn’t matter. They could even just write down on a piece of
paper how many coupons the children owe them, how many they have earned and how
many they’ve paid each month. When the federal government spends, the funds
don’t “come from” anywhere any more than the points “come from” somewhere at the
football stadium or the bowling alley. Nor does collecting taxes (or borrowing)
somehow increase the government’s “hoard of funds” available for spending.

In fact, the people at the U.S.
Treasury who actually spend the money (by changing numbers on bank accounts up)
don’t even have the telephone numbers of - nor are they in contact with - the
people at the IRS who collect taxes (they change the numbers on bank accounts
down), or the other people at the U.S. Treasury who do the “borrowing” (issue
the Treasury securities). If it mattered at all how much was taxed or borrowed
to be able to spend, you’d think they at least would know each other’s phone
numbers! Clearly, it doesn’t matter for their purposes.

From our point of view (not the
federal government’s), we need to first have U.S. dollars to be able to make
payments.

Just like the children need to earn
the coupons from their parents before they can make their weekly coupon
payments.

And state governments, cities, and
businesses are all in that same boat as well. They all need to be able to
somehow get dollars before they can spend them. That could mean earning them, borrowing
them, or selling something to get the dollars they need to be able to spend. In
fact, as a point of logic, the dollars we need to pay taxes must, directly or
indirectly, from the inception of the currency, come from government spending (or
government lending, which I’ll discuss later).

Now let’s build a national currency
from scratch. Imagine a new country with a newly announced currency. No one has
any. Then the government proclaims, for example, that there will be a property
tax. Well, how can it be paid? It can’t, until after the government starts
spending. Only after the government spends its new currency does the population
have the funds to pay the tax.

To repeat: the funds to pay taxes,
from inception, come from government spending (or lending). Where else can they
come from? (2)

Yes, that means that the government
has to spend first, to ultimately provide us with the funds we need to pay our taxes.
The government, in this case, is just like the parents who have to spend their
coupons first, before they can start actually collecting them from their
children. And, neither the government, nor the parents, from inception, can
collect more of their own currency than they spend. Where else could it possibly
come from?

So while our politicians truly believe
the government needs to take our dollars, either by taxing or borrowing, for them
to be able to spend, the truth is: We need the federal government’s spending to
get the funds we need to pay our taxes.

We don’t get to change numbers, like
the federal government does (or the bowling alley and the football stadium).
(4)

And just like the children who have
to earn or somehow get their coupons to make their coupon payments, we have to
earn or somehow get US dollars to make our tax payments. And, as you now understand,
this is just like it happens in any household that issues its own coupons. The coupons
the kids need to make their payments to their parents have to come from their
parents.

And, as previously stated, government
spending is in no case operationally constrained by revenues (tax payments and borrowings).
Yes, there can be and there are “self-imposed” constraints on spending put
there by Congress, but that’s an entirely different matter. These include
debt-ceiling rules, Treasury-overdraft rules, and restrictions of the Fed buying
securities from the Treasury. They are all imposed by a Congress that does not
have a working knowledge of the monetary system. And, with our current monetary
arrangements, all of those self-imposed constraints are counterproductive with
regard to furthering public purpose.

All they do is put blockages in the
monetary plumbing that wouldn’t otherwise be there, and from time to time, create
problems that wouldn’t otherwise arise. In fact, it was some of these self-imposed
blockages that caused the latest financial crisis to spill over to the real
economy and contribute to the recession.

The fact that government spending is
in no case operationally constrained by revenues means there is no “solvency
risk.” In other words, the federal government can always make any and all
payments in its own currency, no matter how large the deficit is, or how few
taxes it collects.

This, however, does NOT mean that the
government can spend all it wants without consequence. Over-spending can drive
up prices and fuel inflation.

What it does mean is that there is no
solvency risk, which is to say that the federal government can’t go broke, and
there is no such thing as our government “running out of money to spend,” as
President Obama has incorrectly stated repeatedly.

Nor, as President Obama also stated,
is U.S. government spending limited by what it can borrow.

So the next time you hear: “Where will
the money for Social Security come from?” go ahead and tell them, “It’s just
data entry. It comes from the same place as your score at the bowling alley.”

Putting it yet another way, U.S.
government checks don’t bounce, unless the government decides to bounce its own
checks.

Federal Government
checks don’t bounce.

A few years ago I gave a talk titled,
“Government Checks Don’t Bounce” in Australia at an economics conference. In the
audience was the head of research for the Reserve Bank of Australia, Mr. David
Gruen. It was high drama. I had been giving talks for several years to this
group of academics, and

I had not convinced most of them that
government solvency wasn’t an issue. They always started with the familiar,
“What Americans don’t understand is that it’s different for a small, open
economy like Australia than it is for the United States.”

There seemed to be no way to get it
through their (perhaps) over-educated skulls that at least for this purpose,
none of that matters. A spreadsheet is a spreadsheet. All but one Professor Bill
Mitchell and a few of his colleagues seemed to have this mental block, and they
deeply feared what would happen if the markets turned against Australia to
somehow keep them from being able to “finance the deficit.”

So I began my talk about how U.S.
government checks don’t bounce, and after a few minutes, David’s hand shot up with
the statement familiar to all modestly-advanced economic students: “If the
interest rate on the debt is higher than the rate of growth of GDP, then the
government’s debt is unsustainable.”

This wasn’t even presented as a question,
but stated as a fact. I then replied, “I’m an operations type of guy, David, so
tell me, what do you mean by the word ‘unsustainable’? Do you mean that if the
interest rate is very high, and that in 20 years from now the government debt
has grown to a large enough number, the government won’t be able to make its
interest payments? And if it then writes a check to a pensioner, that that
check will bounce?”

David got very quiet, deep in thought,
thinking it through.

“You know, when I came here, I didn’t
think I’d have to think through how the Reserve Bank’s check-clearing works,”
he stated, in an attempt at humor. But no one in the room laughed or made a
sound. They were totally focused on what his answer might be.

It was a “showdown” on this issue. David
finally said, “No, we’ll clear the check, but it will cause inflation and the
currency will go down. That’s what people mean by unsustainable.”

There was dead silence in the room.
The long debate was over. Solvency is not an issue, even for a small, open
economy. Bill and I instantly commanded an elevated level of respect, which
took the usual outward form of “well of course, we always said that” from the
former doubters and skeptics.

I continued with David, “Well, I think
most pensioners are concerned about whether the funds will be there when they
retire, and whether the Australian government will be able to pay them.” To
which David replied, “No, I think they are worried about inflation and the
level of the Australian dollar.” Then Professor Martin Watts, head of the
Economics Department at the University of Newcastle inserted, “The Hell they
are, David!” At that, David very thoughtfully conceded,

“Yes, I suppose you’re right.”

So, what was actually confirmed to the
Sydney academics in attendance that day?  Governments, using their own currency,
can spend what they want, when they want, just like the football stadium can
put points on the board at will. The consequences of overspending might be
inflation or a falling currency, but never bounced checks.

The fact is: government deficits can
never cause a government to miss any size of payment. There is no solvency issue.
There is no such thing as running out of money when spending is just changing
numbers upwards in bank accounts at its own Federal Reserve Bank.

Yes, households, businesses, and even
the states need to have dollars in their bank accounts when they write checks,
or else those checks will bounce. That’s because the dollars they spend are
created by someone else - the federal government - and households, businesses,
and the states are not the scorekeeper for the dollar.

Why the Federal Government Taxes

So why then does the federal
government tax us, if it doesn’t actually get anything to spend or need to get
anything to spend? (Hint: it’s the same reason that the parents demand 10
coupons a week from their children, when the parents don’t actually need the
coupons for anything.)

There is a very good reason it taxes
us. Taxes create an ongoing need in the economy to get dollars, and therefore
an ongoing need for people to sell their goods and services and labor to get
dollars. With tax liabilities in place, the government can buy things with its
otherwise-worthless dollars, because someone needs the dollars to pay taxes.
Just like the coupon tax on the children creates an ongoing need for the
coupons, which can be earned by doing chores for the parents. Think of a
property tax. (You’re not ready to think about income taxes - it comes down to
the same thing, but it’s a lot more indirect and complicated). You have to pay
the property tax in dollars or lose your house. It’s just like the kids’
situation, as they need to get 10 coupons or face the consequences. So now you
are motivated to sell things - goods, services, your own labor - to get the
dollars you need. It’s just like the kids, who are motivated to do chores to
get the coupons they need.

Finally, I have to connect the dots
from some people needing dollars to pay their taxes to everyone wanting and using
dollars for almost all of their buying and selling. To do that, let’s go back
to the example of a new country with a new currency, which I’ll call “the crown,”
where the government levies a property tax. Let’s assume the government levies
this tax for the further purpose of raising an army, and offers jobs to soldiers
who are paid in “crowns.” Suddenly, a lot of people who own property now need
to get crowns, and many of them won’t want to get crowns directly from the
government by serving as soldiers. So they start offering their goods and services
for sale in exchange for the new crowns they need and want, hoping to get these
crowns without having to join the army. Other people now see many things for
sale they would like to have - chickens, corn, clothing and all kinds of
services like haircuts, medical services and many other services. The sellers
of these goods and services want to receive crowns to avoid having to join the
army to get the money they need to pay their taxes. The fact that all these
things are being offered for sale in exchange for crowns makes some other
people join the army to get the money needed to buy some of those goods and
services.

In fact, prices will adjust until as
many soldiers as the government wants are enticed to join the army. Because
until that happens, there won’t be enough crowns spent by the government to
allow the taxpayers to pay all of their taxes, and those needing the crowns,
who don’t want to go into the army, will cut the prices of their goods and
services as much as they have to in order to get them sold, or else throw in
the towel and join the army themselves.

The following is not merely a theoretical
concept. It’s exactly what happened in Africa in the 1800’s, when the British
established colonies there to grow crops. The British offered jobs to the local
population, but none of them were interested in earning British coins. So the
British placed a “hut tax” on all of their dwellings, payable only in British
coins. Suddenly, the area was “monetized,” as everyone now needed British
coins, and the local population started offering things for sale, as well as
their labor, to get the needed coins. The British could then hire them and pay
them in British coins to work the fields and grow their crops.

This is exactly what the parents did
to get labor hours from their children to get the chores done. And that’s
exactly how what are called “non-convertible currencies” work (no more gold
standards and very few fixed exchange rates are left), like the U.S. dollar, Japanese
yen, and British pound.

Now we’re ready to look at the role of
taxes from a different angle, that of today’s economy, using the language of
economics. A learned economist today would say that “taxes function to reduce aggregate
demand.” Their term, “aggregate demand,” is just a fancy term for “spending
power.”

The government taxes us and takes away
our money for one reason - so we have that much less to spend which makes the
currency that much more scarce and valuable. Taking away our money can also be thought
of as leaving room for the government to spend without causing inflation. Think
of the economy as one big department store full of all the goods and services
we all produce and offer for sale every year. We all get paid enough in wages
and profits to buy everything in that store, assuming we would spend all the
money we earn and all the profits we make. (And if we borrow to spend, we can
buy even more than there is in that store.) But when some of our money goes to
pay taxes, we are left short of the spending power we need to buy all of what’s
for sale in the store. This gives government the “room” to buy what it wants.
So when the government spends what it wants, the combined spending of
government and the rest of us is not too much for what’s for sale in the store.

However, when the government taxes too
much - relative to its spending - total spending isn’t enough to make sure everything
in the store gets sold. When businesses can’t sell all that they produce,
people lose their jobs and have even less money to spend, so even less gets
sold. Then more people lose their jobs, and the economy goes into a downward
spiral we call a recession.

Keep in mind that the public purpose
behind government doing all this is to provide a public infrastructure. This
includes the military, the legal system, the legislature and the executive branch
of government, etc. So there is quite a bit that even the most conservative
voters would have the government do.

So I look at it this way: for the
“right” amount of government spending, which we presume is necessary to run the
nation the way we would like to see it run, how high should taxes be? The
reason I look at it this way is because the “right amount of government
spending” is an economic and political decision that, properly understood, has
nothing to do with government finances. The real “costs” of running the
government are the real goods and services it consumes - all the labor hours,
fuel, electricity, steel, carbon fiber, hard drives, etc. that would otherwise
be available for the private sector. So when the government takes those real
resources for its own purposes, there are that many fewer real resources left for
private-sector activity. For example, the real cost of the “right-size” army
with enough soldiers for defense is that there are fewer workers left in the private
sector to grow the food, build the cars, do the doctoring and nursing and
administrative tasks, sell us stocks and real estate, paint our houses, mow our
lawns, etc. etc. etc.

Therefore, the way I see it, we first
set the size of government at the “right” level of public infrastructure, based
on real benefits and real costs, and not the “financial” considerations. The
monetary system is then the tool we use to achieve our real economic and political
objectives, and not the source of information as to what those objectives are.
Then, after deciding what we need to spend to have the right-sized government, we
adjust taxes so that we all have enough spending power to buy what’s still for
sale in the “store” after the government is done with its shopping. In general,

I’d expect taxes to be quite a bit lower
than government spending, for reasons already explained and also expanded on
later in this book. In fact, a budget deficit of perhaps 5% of our gross
domestic product might turn out to be the norm, which in today’s economy is
about $750 billion annually. However, that number by itself is of no particular
economic consequence, and could be a lot higher or a lot lower, depending on
the circumstances. What matters is that the purpose of taxes is to balance the
economy and make sure it’s not too hot or too cold. And federal government
spending is set at this right amount, given the size and scope of government we
want.

That means we should NOT grow the size
of government to help the economy out of a slowdown. We should already be at
the right size for government, and therefore not add to it every time the
economy slows down. So while increasing government spending during a slowdown
will indeed make the numbers work, and will end the recession, for me that is far
less desirable than accomplishing the same thing with the right tax cuts in
sufficient-enough size to restore private-sector spending to the desired
amounts.

Even worse is increasing the size of
government just because the government might find itself with a surplus.

Again, government finances tell us
nothing about how large the government should be. That decision is totally
independent of government finances. The right amount of government spending has
nothing to do with tax revenues or the ability to borrow, as both of those are
only tools for implementing policy on behalf of public purpose, and not reasons
for spending or not spending, and not sources of revenue needed for actual
government spending.

I’ll get specific on what role I see
for government later in this book, but rest assured, my vision is for a far
more streamlined and efficient government, one that is intensely focused on the
basics of fundamental public purpose.

Fortunately, there are readily
available and infinitely sensible ways to do this. We can put the right
incentives in place which channel market forces with guidance to better promote
the public purpose with far less regulation. This will result in a government and
culture that will continue to be the envy of the world. It will be a government
that expresses our American values of rewarding hard work and innovation, and
promoting equal opportunity, equitable outcomes and enforceable laws and
regulations we can respect with true pride.

But I digress. Returning to the issue
of how high taxes need to be, recall that if the government simply tried to buy
what it wanted to buy and didn’t take away any of our spending power, there
would be no taxes - it would be “too much money chasing too few goods,” with the
result being inflation. In fact, with no taxes, nothing would even be offered
for sale in exchange for the government money in the first place, as previously
discussed.

To prevent the government’s spending
from causing that kind of inflation, the government must take away some of our spending
power by taxing us, not to actually pay for anything, but so that their
spending won’t cause inflation. An economist would say it this way: taxes function
to regulate aggregate demand, not to raise revenue per se. In other words, the government
taxes us, and takes away our money, to prevent inflation, not to actually get our
money in order to spend it.

RESTATED ONE MORE TIME: TAXES
FUNCTION TO REGULATE THE ECONOMY, AND NOT TO GET MONEY FOR CONGRESS TO SPEND.

And, again, the government neither has
nor doesn’t have dollars; it simply changes numbers in our bank accounts upward
when it spends and downwards when it taxes. All of this is, presumably, for the
public purpose of regulating the economy.

But as long as government continues to
believe this first of the seven deadly innocent frauds, that they need to get
money from taxing or borrowing in order to spend, they will continue to support
policies that constrain output and employment and prevent us from achieving
what are otherwise readily-available economic outcomes.

Deadly Innocent Fraud #2:

With government deficits,
we are leaving our debt burden to our children.

FACT: COLLECTIVELY,
IN REAL TERMS, THERE IS NO SUCH BURDEN POSSIBLE. DEBT OR NO DEBT, OUR CHILDREN
GET TO CONSUME WHATEVER THEY CAN PRODUCE.

This deadly innocent fraud is often
the first answer most people give to what they perceive to be the main problem associated
with government deficit spending. Borrowing now means paying for today’s
spending later. Or, as commonly seen and heard in the media: “Higher deficits
today mean higher taxes tomorrow.”

And paying later means that somehow
our children’s real standard of living and general well-being will be lowered
in the future because of our deficit spending now.

Professional economists call this the
“intergenerational” debt issue. It is thought that if the federal government
deficit spends, it is somehow leaving the real burden of today’s expenditures
to be paid for by future generations.

And the numbers are staggering! But,
fortunately, like all of the seven deadly innocent frauds, it is all readily
dismissed in a way that can be easily understood. In fact, the idea of our
children being somehow necessarily deprived of real goods and services in the
future because of what’s called the national debt is nothing less than ridiculous.

Here’s a story that illustrates the point.
Several years ago, I ran into former Senator and Governor of Connecticut,
Lowell Weicker, and his wife Claudia on a boat dock in
St. Croix. I asked Governor Weicker what was wrong with the country’s fiscal
policy. He replied we have to stop running up these deficits and leaving the burden
of paying for today’s spending to our children.

So I then asked him the following
questions to hopefully illustrate the hidden flaw in his logic: “When our
children build 15 million cars per year 20 years from now, will they have to
send them back in time to 2008 to pay off their debt?

Are we still sending real goods and
services back in time to 1945 to pay off the lingering debt from World War II?”

And today, as I run for the U.S.
Senate in Connecticut, nothing has changed. The ongoing theme of the other candidates
is that we are borrowing from the likes of China to pay for today’s spending
and leaving our children and grandchildren to pay the bill.

Of course, we all know we don’t send
real goods and services back in time to pay off federal government deficits, and
that our children won’t have to do that either.

Nor is there any reason government
spending from previous years should prevent our children from going to work and
producing all the goods and services they are capable of producing. And in our
children’s future, just like today, whoever is alive will be able to go to work
and produce and consume their real output of goods and services, no matter how
many U.S.

Treasury securities are outstanding.
There is no such thing as giving up current-year output to the past, and
sending it back in time to previous generations. Our children won’t and can’t
pay us back for anything we leave them, even if they wanted to.

Nor is the financing of deficit
spending anything of any consequence. When government spends, it just changes numbers
up in our bank accounts. More specifically, all the commercial banks we use for
our banking have bank accounts at the Fed called reserve accounts. Foreign
governments have reserve accounts at the Fed as well. These reserve accounts at
the Fed are just like checking accounts at any other bank.

When government spends without taxing,
all it does is change the numbers up in the appropriate checking account
(reserve account) at the Fed. This means that when the government makes a $2,000
Social Security payment to you, for example, it changes the number up in your bank’s
checking account at the Fed by $2,000, which also automatically changes the number
up in your account at your bank by $2,000.

Next, you need to know what a U.S.
Treasury security actually is. A U.S. Treasury security is nothing more than a savings
account at the Fed. When you buy a Treasury security, you send your dollars to
the Fed and then some time in the future, they send the dollars back plus
interest. The same holds true for any savings account at any bank. You send the
bank dollars and you get them back plus interest. Let’s say that your bank
decides to buy $2,000 worth of Treasury securities. To pay for those Treasury
securities, the Fed reduces the number of dollars that your bank has in its
checking account at the Fed by $2,000 and adds $2,000 to your bank’s savings
account at the Fed. (I’m calling the Treasury securities “savings accounts,”
which is all they are.)

In other words, when the U.S.
government does what’s called “borrowing money,” all it does is move funds from
checking accounts at the Fed to savings accounts (Treasury securities) at the
Fed. In fact, the entire $13 trillion national debt is nothing more than the
economy’s total holdings of savings accounts at the Fed. And what happens when
the Treasury securities come due, and that “debt” has to be paid back? Yes, you
guessed it, the Fed merely shifts the dollar balances from the savings accounts
(Treasury securities) at the Fed to the appropriate checking accounts at the
Fed (reserve accounts). This is not anything new.

It’s been done exactly like this for a
very long time, and no one seems to understand how simple it is and that it
never will be a problem.

Federal Government
Taxing and Spending Does Influence Distribution

Distribution is about who gets all the
goods and services that are produced. In fact, this is what politicians do
every time they pass legislation. They re-direct real goods and services by
decree, for better or worse. And the odds of doing it for better are
substantially decreased when they don’t understand the Seven Deadly Innocent Frauds.
Each year, for example, Congress discusses tax policy, always with an eye to
the distribution of income and spending. Many seek to tax those “who can most
afford it” and direct federal spending to “those in need.” And they also decide
how to tax interest, capital gains, estates, etc. as well as how to tax income.
All of these are distributional issues.

In addition, Congress decides who the
government hires and fires, who it buys things from, and who gets direct payments.
Congress also makes laws that directly affect many other aspects of prices and
incomes.

Foreigners who hold U.S. dollars are
particularly at risk.

They earn those dollars from selling
us real goods and services, yet they have no assurance that they will be able
to buy real goods and services from us in the future. Prices could go up (inflation)
and the U.S. government could legally impose all kinds of taxes on anything foreigners
wish to buy from us, which reduces their spending power.

Think of all those cars Japan sold to
us for under $2,000 years ago. They’ve been holding those dollars in their
savings accounts at the Fed (they own U.S. Treasury securities), and if they
now would want to spend those dollars, they would probably have to pay in
excess of $20,000 per car to buy cars from us. What can they do about the
higher prices? Call the manager and complain? They’ve traded millions of
perfectly good cars to us in exchange for credit balances on the Fed’s books
that can buy only what we allow them to buy. And look at what happened recently
- the Federal Reserve cut rates, which reduced the interest Japan earns on its
U.S.-Treasury securities. (This discussion continues in a subsequent innocent
fraud.)

This is all perfectly legal and
business as usual, as each year’s output is “divided up” among the living. None
of the real output gets “thrown away” because of outstanding debt, no matter
how large. Nor does outstanding debt reduce output and employment, except of
course when ill-informed policymakers decide to take anti-deficit measures that
do reduce output and employment. Unfortunately, that is currently the case, and
that is why this is a deadly innocent fraud.

Today (April 15, 2010), it’s clear
that Congress is taking more spending power away from us in taxes than is
needed to make room for their own spending. Even after we spend what we want
and the government does all of its massive spending, there’s still a lot left
unsold in that big department store called the economy.

How do we know that? Easy! Count the
bodies in the unemployment lines. Look at the massive amount of excess capacity
in the economy. Look at what the Fed calls the “output gap,” which is the difference
between what we could produce at full employment and what we are now producing.

It’s enormous. Sure, there’s a record
deficit and national debt, which, you now know, means that we all have that
much in savings accounts at the Fed called Treasury securities. Incidentally, the
cumulative U.S. budget deficit, adjusted for the size of the economy, is still
far below Japan’s, far below most of Europe and very far below the World War II
U.S. deficits that got us out of the Depression (with no debt burden
consequences).

If you’ve gotten this far into this
book you may already know why the size of the deficit isn’t a financial issue.
So hopefully, you know that taxes function to regulate the economy, and not to
raise revenue, as Congress thinks. When I look at today’s economy, it’s screaming
at me that the problem is that people don’t have enough money to spend. It’s
not telling me they have too much spending power and are overspending. Who
would not agree?

Unemployment has doubled and GDP is
more than 10% below where it would be if Congress wasn’t over-taxing us and taking
so much spending power away from us.

When we operate at less than our
potential - at less than full employment - then we are depriving our children of
the real goods and services we could be producing on their behalf. Likewise, when
we cut back on our support of higher education, we are depriving our children
of the knowledge they’ll need to be the very best they can be in their future.
So also, when we cut back on basic research and space exploration, we are
depriving our children of all the fruits of that labor that instead we are
transferring to the unemployment lines.

So yes, those alive get to consume
this year’s output, and also get to decide to use some of the output as
“investment goods and services,” which should increase future output.

And yes, Congress has a big say in who
consumes this year’s output. Potential distributional issues due to previous
federal deficits can be readily addressed by Congress and distribution can be
legally altered to their satisfaction.

So How Do We Pay Off
China?

Those worried about paying off the
national debt can’t possibly understand how it all works at the operational, nuts
and bolts (debits and credits) level. Otherwise they would realize that
question is entirely inapplicable. What they don’t understand is that both
dollars and U.S. Treasury debt (securities) are nothing more than “accounts,”
which are nothing more than numbers that the government makes on its own books.

So let’s start by looking at how we
got to where we are today with China. It all started when China wanted to sell things
to us and we wanted to buy them. For example, let’s suppose that the U.S. Army
wanted to buy $1 billion worth of uniforms from China, and China wanted to sell
$1 billion worth of uniforms to the U.S. Army at that price. So the Army buys $1
billion worth of uniforms from China. First, understand that both parties are
happy. There is no “imbalance.” China would rather have the 1 billion U.S. dollars
than the uniforms or they wouldn’t have sold them, and the U.S. Army would
rather have the uniforms than the money or it wouldn’t have bought them.

The transactions are all voluntary,
and all in U.S. dollars. But back to our point - how does China get paid?

China has a reserve account at the
Federal Reserve Bank. To quickly review, a reserve account is nothing more than
a fancy name for a checking account. It’s the Federal Reserve Bank so they call
it a reserve account instead of a checking account. To pay China, the Fed adds
1 billion U.S. dollars to China’s checking account at the Fed. It does this by
changing the numbers in China’s checking account up by 1 billion U.S. dollars.
The numbers don’t come from anywhere any more than the numbers on a scoreboard
at a football come from anywhere. China then has some choices. It can do
nothing and keep the $1 billion in its checking account at the Fed, or it can
buy U.S. Treasury securities.

Again, to quickly review, a U.S.
Treasury security is nothing more than a fancy name for a savings account at
the Fed. The buyer gives the Fed money, and gets it back later with interest. That’s
what a savings account is - you give money to a bank and you get it back later
with interest.

So let’s say China buys a one-year
Treasury security. All that happens is that the Fed subtracts $1 billion from
China’s checking account at the Fed, and adds $1 billion to China’s savings
account at the Fed. And all that happens a year later when China’s one-year
Treasury bill comes due is that the Fed removes this money from China’s savings
account at the Fed (including interest) and adds it to China’s checking account
at the Fed.

Right now, China is holding some $2
trillion of U.S. Treasury securities. So what do we do when they mature and it’s
time to pay China back? We remove those dollars from their savings account at
the Fed and add them to their checking account at the Fed, and wait for them to
say what, if anything, they might want to do next. This is what happens when
all U.S. government debt comes due, which happens continuously. The Fed removes
dollars from savings accounts and adds dollars to checking accounts on its
books. When people buy Treasury securities, the Fed removes dollars from their
checking accounts and adds them to their savings accounts. So what’s all the
fuss?

It’s all a tragic misunderstanding. China
knows we don’t need them for “financing our deficits” and is playing us for
fools. Today, that includes Geithner, Clinton, Obama, Summers and the rest of
the administration. It also includes Congress and the media.

Now let me describe this all in a more
technical manner for those of you who may be interested. When a Treasury bill,
note or bond is purchased by a bank, for example, the government makes two
entries on its spreadsheet that we call the “monetary system.” First, it debits
(subtracts from) the buyer’s reserve account (checking account) at the Fed.
Then it increases (credits) the buyer’s securities account (savings account) at
the Fed. As before, the government simply changes numbers on its own
spreadsheet - one number gets changed down and another gets changed up. And
when the dreaded day arrives, and the Treasury securities which China holds come
due and need to be repaid, the Fed again simply changes two numbers on its own spreadsheet.
The Fed debits (subtracts from) China’s securities account at the Fed. And then
it credits (adds to) China’s reserve (checking) account at the Fed. That’s all –
the debt is paid!

China now has its money back. It has a
(very large) U.S. - dollar balance in its checking account at the Fed. If it
wants anything else - cars, boats, real estate, and other currencies - it has to
buy them at market prices from a willing seller who wants dollar deposits in
return. And if China does buy something, the Fed will subtract that amount from
China’s checking account and add that amount to the checking account of
whomever China bought it all from.

Notice too, that “paying off China”
doesn’t change China’s stated $U.S. wealth. They simply have dollars in a
checking account rather than U.S. Treasury securities (a savings account) of
equal dollars. And if they want more Treasury securities instead, no problem,
the Fed just moves their U.S. dollars from their checking account to their
savings account again, by appropriately changing the numbers.

Paying off the entire U.S. national
debt is but a matter of subtracting the value of the maturing securities from one
account at the Fed, and adding that value to another account at the Fed. These
transfers are non-events for the real economy and not the source of dire stress
presumed by mainstream economists, politicians, businesspeople, and the media.

One more time: to pay off the national
debt the government changes two entries in its own spreadsheet - a number that says
how many securities are owned by the private sector is changed down and another
number that says how many U.S. dollars are being kept at the Fed in reserve
accounts is changed up. Nothing more. Debt paid. All creditors have their money
back. What’s the big deal?

So what happens if China refuses to
buy our debt at current low-interest rates paid to them? Interest rates have to
go up to attract their purchase of the Treasury Securities, right?

Wrong!

They can leave it in their checking
account. It’s of no consequence to a government that understands its own monetary
system. The funds are not used for spending, as previously described. There are
no negative consequences of funds being in a checking account at the Fed rather
than a savings account at the Fed.

What happens if China says, “We don’t
want to keep a checking account at the Fed anymore? Pay us in gold or some other
means of exchange!” They simply do not have this option under our current “fiat
currency” system6 as they would have known when they sold the uniforms to the
U.S. Army and had the money put into their checking account at the Fed.

If they want something other than
dollars, they have to buy it from a willing seller, just like the rest of us do
when we spend our dollars.

Someday it will be our children
changing numbers on what will be their spreadsheet, just as seamlessly as we
did, and our parents did, though hopefully with a better understanding! But for
now, the deadly innocent fraud of leaving the national debt to our children
continues to drive policy, and keeps us from optimizing output and employment.

The lost output and depreciated human
capital is the real price we and our children are paying now that diminishes
both the present and the future. We make do with less than what we can produce
and sustain high levels of unemployment (along with all the associated crime, family
problems and medical issues) while our children are deprived of the real
investments that would have been made on their behalf if we knew how to keep
our human resources fully employed and productive.

Deadly Innocent Fraud #3:

Federal
Government budget deficits take away savings.

FACT: FEDERAL
GOVERNMENT BUDGET DEFICITS ADD TO SAVINGS.

Lawrence Summers

Several years ago I had a meeting with
Senator Tom Daschle and then-Assistant Treasury Secretary Lawrence Summers. I
had been discussing these innocent frauds with the Senator, and explaining how
they were working against the well-being of those who voted for him. So he set
up this meeting with the Assistant Treasury Secretary, who is also a former
Harvard economics professor and has two uncles who have won Nobel prizes in
economics, to get his response and hopefully confirm what I was saying.

I opened with a question: “Larry,
what’s wrong with the budget deficit?” He replied: “It takes away savings that
could be used for investment.” I then objected: “No it doesn’t, all Treasury
securities do is offset operating factors at the Fed. It has nothing to do with
savings and investment.” To which he retorted: “Well, I really don’t understand
reserve accounting, so I can’t discuss it at that level.”

Senator Daschle was looking on at all
this in disbelief. This Harvard professor of economics, Assistant Treasury
Secretary Lawrence Summers didn’t understand reserve accounting?

Sad but true.

So I spent the next twenty minutes
explaining the “paradox of thrift” (more detail on this innocent fraud #6 later)
step by step, which he sort of got right when he finally responded: “…so we need
more investment which will show up as savings?” I responded with a friendly
“yes,” after giving this first year economics lesson to the good Harvard
professor, and ended the meeting. The next day, I saw him on a podium with the
Concord Coalition - a band of deficit terrorists - talking about the grave
dangers of the budget deficit.

This third deadly innocent fraud is
alive and well at the very highest levels. So here’s how it really works, and
it could not be simpler: Any $U.S. government deficit exactly EQUALS the total
net increase in the holdings ($U.S. financial assets) of the rest of us -
businesses and households, residents and nonresidents - what is called the
“non-government” sector.

In other words, government deficits
equal increased “monetary savings” for the rest of us, to the penny.

Simply put, government deficits ADD to
our savings (to the penny). This is an accounting fact, not theory or
philosophy.

There is no dispute. It is basic national
income accounting. For example, if the government deficit last year was $1
trillion, it means that the net increase in savings of financial assets for everyone
else combined was exactly, to the penny, $1 trillion. (For those who took some
economics courses, you might remember that net savings of financial assets is
held as some combination of actual cash, Treasury securities and member bank
deposits at the Federal Reserve.) This is Economics 101 and first year money banking.
It is beyond dispute. It’s an accounting identity. Yet it’s misrepresented
continuously, and at the highest levels of political authority. They are just
plain wrong.

Just ask anyone at the CBO
(Congressional Budget Office), as I have, and they will tell you they must
“balance the checkbook” and make sure the government deficit equals our new
savings, or they would have to stay late and find their accounting mistake.

As before, it’s just a bunch of
spreadsheet entries on the government’s own spreadsheet. When the accountants debit
(subtract from) the account called “government” when government spends, they
also credit (add to) the accounts of whoever gets those funds. When the
government account goes down, some other account goes up, by exactly the same amount.

Next is an example of how,
operationally, government deficits add to savings. This also puts to rest a
ridiculous new take on this innocent fraud that’s popped up recently: “Deficit
spending means the government borrows from one person and gives it to another,
so nothing new is added - it’s just a shift of money from one person to
another.” In other words, they are saying that deficits don’t add to our
savings, but just shift savings around. This could not be more wrong! So let’s
demonstrate how deficits do ADD to savings, and not just shift savings:

1. Start
with the government selling $100 billion in Treasury securities. (Note: this
sale is voluntary, which means that the buyer buys the securities because he
wants to. Presumably, he believes that he is better off buying them than not
buying them. No one is ever forced to buy government securities. They get sold
at auction to the highest bidder who is willing to accept the lowest yield.)

2. When
the buyers of these securities pay for them, checking accounts at the Fed are
reduced by $100 billion to make the payment. In other words, money in checking
accounts at the Fed is exchanged for the new Treasury securities, which are
savings accounts at the Fed. At this point, non-government savings is unchanged.
The buyers now have their new Treasury securities as savings, rather than the
money that was in their checking accounts before they bought the Treasury
securities.

3. Now
the Treasury spends $100 billion after the sale of the $100 billion of new
Treasury securities, on the usual things government spends its money on.

4. This
Treasury spending adds back $100 billion to someone’s checking accounts.

5. The
non-government sector now has its $100 billion of checking accounts back AND it
has the $100 billion of new Treasury securities.

Bottom line: the deficit spending of
$100 billion directly added $100 billion of savings in the form of new Treasury
securities to non-government savings (non-government means everyone but the
government).

The savings of the buyer of the $100
billion of new Treasury securities shifted from money in his checking account
to his holdings of the Treasury securities (savings accounts).  Then when the
Treasury spent $100 billion after selling the Treasury securities, the savings
of recipients of that $100 billion of spending saw their checking accounts increase
by that amount.

So, to the original point, deficit
spending doesn’t just shift financial assets (U.S. dollars and Treasury
securities) outside of the government. Instead, deficit spending directly adds
exactly that amount of savings of financial assets to the non-government
sector. And likewise, a federal budget surplus directly subtracts exactly that
much from our savings. And the media and politicians and even top economists
all have it BACKWARDS!

In July 1999, the front page of the Wall
Street Journal had two headlines. Towards the left was a headline praising President
Clinton and the record government budget surplus, and explaining how well fiscal
policy was working. On the right margin was a headline stating that Americans
weren’t saving enough and we would have to work harder to save more. Then a few
pages later, there was a graph with one line showing the surplus going up, and
another line showing savings going down. They were nearly identical, but going
in opposite directions, and clearly showing the gains in the government surplus
roughly equaled the losses in private savings.

There can’t be a budget surplus with
private savings increasing (including non-resident savings of $U.S. financial assets).
There is no such thing, yet not a single mainstream economist or government
official had it right.

Al Gore

Early in 2000, in a private home in
Boca Raton, FL, I was seated next to then-Presidential Candidate Al Gore at a fundraiser/dinner
to discuss the economy. The first thing he asked was how I thought the next
president should spend the coming $5.6 trillion surplus that was forecasted for
the next 10 years. I explained that there wasn’t going to be a $5.6 trillion surplus,
because that would mean a $5.6 trillion drop in nongovernment savings of
financial assets, which was a ridiculous proposition. At the time, the private
sector didn’t even have that much in savings to be taxed away by the
government, and the latest surplus of several hundred billion dollars had
already removed more than enough private savings to turn the Clinton boom into
the soon-to-come bust.

I pointed out to Candidate Gore that
the last six periods of surplus in our more than two hundred-year history had
been followed by the only six depressions in our history. Also, I mentioned
that the coming bust would be due to allowing the budget to go into surplus and
drain our savings, resulting in a recession that would not end until the
deficit got high enough to add back our lost income and savings and deliver the
aggregate demand needed to restore output and employment.

I suggested that the $5.6 trillion
surplus which was forecasted for the next decade would more likely be a $5.6
trillion deficit, as normal savings desires are likely to average 5% of GDP
over that period of time.

That is pretty much what happened. The
economy fell apart, and President Bush temporarily reversed it with his massive
deficit spending in 2003. But after that, and before we had had enough deficit
spending to replace the financial assets lost to the Clinton surplus years (a
budget surplus takes away exactly that much savings from the rest of us), we
let the deficit get too small again. And after the sub-prime debt-driven bubble
burst, we again fell apart due to a deficit that was and remains far too small
for the circumstances.

For the current level of government
spending, we are being over-taxed and we don’t have enough after-tax income to
buy what’s for sale in that big department store called the economy.

Anyway, Al was a good student, went
over all the details, agreeing that it made sense and was indeed what might
happen.

However, he said he couldn’t “go
there.” I told him that I understood the political realities, as he got up and
gave his talk about how he was going to spend the coming surpluses.

Robert Rubin

Ten years ago, around the year 2000
just before it all fell apart, I found myself in a private client meeting at
Citibank with Robert Rubin, former U.S. Treasury Secretary under President
Clinton, and about 20 Citibank clients. Mr. Rubin gave his take on the economy
and indicated that the low savings rate might turn out to be a problem. With
just a few minutes left, I told him I agreed about the low savings rate being
an issue and added, “Bob, does anyone in Washington realize that the budget
surplus takes away savings from the non-government sectors?” He replied, “No,
the surplus adds to savings. When the government runs a surplus, it buys Treasury
securities in the market, and that adds to savings and investment.” To that I
responded, “No, when we run a surplus, we have to sell our securities to the
Fed (cash in our savings accounts at the Fed) to get the money to pay our
taxes, and our net financial assets and savings go down by the amount of the surplus.”
Rubin stated, “No, I think you’re wrong.” I let it go and the meeting was over.
My question was answered. If he didn’t understand surpluses removed savings,
then no one in the Clinton administration did. And the economy crashed soon
afterwards.

When the January 2009 savings report
was released, and the press noted that the rise in savings to 5% of GDP was the
highest since 1995, they failed to note the current budget deficit passed 5% of
GDP, which also happens to be the highest it’s been since 1995.

Clearly, the mainstream doesn’t yet realize
that deficits add to savings. And if Al Gore does, he isn’t saying anything.

So watch this year as the federal
deficit goes up and savings, too, goes up. Again, the only source of “net $U.S.
monetary savings” (financial assets) for the non-government sectors combined
(both residents and non-residents) is U.S. government deficit spending.

But watch how the very people who want
us to save more, at the same time want to “balance the budget” by taking away our
savings, either through spending cuts or tax increases.

They are all talking out of both sides
of their mouths. They are part of the problem, not part of the solution. And
they are at the very highest levels. Except for one, Professor Wynne Godley.

Professor Wynne Godley

Professor Wynne Godley, retired head
of Economics at Cambridge University and now over 80 years old, was widely
renowned as the most successful forecaster of the British economy for multiple
decades. And he did it all with his “sector analysis,” which had at its core
the fact that the government deficit equals the savings of financial assets of
the other sectors combined. However, even with the success of his forecasting,
the iron-clad support from the pure accounting facts, and the weight of his office
(all of which continues to this day), he has yet to convince the mainstream of
the validity of his teachings.

So now we know:

- Federal
deficits are not the “awful things” that the mainstream believes them to be.
Yes, deficits do matter. Excess spending can cause inflation. But the government
isn’t going to go broke.

- Federal deficits won’t burden our
children.

- Federal deficits don’t just shift
funds from one person to another.

- Federal deficits add to our savings.

So what is the role of deficits in
regard to policy? It’s very simple. Whenever spending falls short of sustaining
our output and employment, when we don’t have enough spending power to buy
what’s for sale in that big department store we call the economy, government
can act to make sure that our own output is sold by either cutting taxes or
increasing government spending.

Taxes function to regulate our
spending power and the economy in general. If the “right” level of taxation
needed to support output and employment happens to be a lot less than government
spending, that resulting budget deficit is nothing to be afraid of regarding
solvency, sustainability, or doing bad by our children.

If people want to work and earn money
but don’t want to spend it, fine! Government can either keep cutting taxes
until we decide to spend and buy our own output, and/or buy the output (award
contracts for infrastructure repairs, national security, medical research, and
the like). The choices are political. The right-sized deficit is the one that
gets us to where we want to be with regards to output and employment, as well as
the size of government we want, no matter how large or how small a deficit that
might be.

What matters is real life - output
and employment – NOT THE SIZE of the deficit, which is in itself is just an accounting statistic.
In the 1940’s, an economist named Abba Lerner called this, “Functional Finance,”
and wrote a book by that name (which is still very relevant today)

Deadly Innocent Fraud #4

Social
Security is broken.

FACT: FEDERAL
GOVERNMENT CHECKS DON’T BOUNCE.

If there is one thing that all members
of Congress believe, it’s that Social Security is broken. President (elect) Obama
has said “the money won’t be there,” President Bush used the word “bankruptcy”
four times in one day and Senator McCain often claims that Social Security is
broken.

They are all wrong.

As we’ve already discussed, the
government never has or doesn’t have any of its own money. It spends by
changing numbers in our bank accounts. This includes Social Security.

There is no operational constraint on
the government’s ability to meet all Social Security payments in a timely
manner. It doesn’t matter what the numbers are in the Social Security

Trust Fund account, because the trust
fund is nothing more than record-keeping, as are all accounts at the Fed.

When it comes time to make Social
Security payments, all the government has to do is change numbers up in the beneficiary’s
accounts, and then change numbers down in the trust fund accounts to keep track
of what it did. If the trust fund number goes negative, so be it. That just
reflects the numbers that are changed up as payments to beneficiaries are made.

One of the major discussions in
Washington is whether or not to privatize Social Security. As you might be
guessing by now, that entire discussion makes no sense whatsoever, so let me
begin with that and then move on.

What is meant by the privatization of
Social Security, and what effect does that have on the economy and you as an
individual?

The idea of privatization is that:

* Social
Security taxes and benefits are reduced.

* The
amount of the tax reduction is used to buy specified shares of stock.

* Because
the government is going to collect that much less in taxes, the budget deficit
will be that much higher, and so the government will have to sell that many
more Treasury securities to “pay for it all” (as they say).

Got it? In simpler words:

- You
have less taken out of your paycheck for Social Security each week.

- You get
to use the funds they no longer take from you to buy stocks.

- You
later will collect a bit less in Social Security payments when you retire.

- You
will own stocks which will hopefully become worth more than the Social Security
payments that you gave up.

From the point of view of the
individual, it looks like an interesting trade-off. The stocks you buy only
have to go up modestly over time for you to be quite a bit ahead.

Those who favor this plan say yes,
it’s a relatively large one-time addition to the deficit, but the savings in
Social Security payments down the road for the government pretty much makes up
for that, and the payments going into the stock market will help the economy
grow and prosper.

Those against the proposal say the
stock market is too risky for this type of thing and point to the large drop in
2008 as an example. And if people lose in the stock market, the government will
be compelled to increase Social Security retirement payments to keep retirees
out of poverty.

Therefore, unless we want to risk a
high percentage of our seniors falling below the poverty line, the government
will be taking all the risk.

They are both terribly mistaken. (Who
would have thought?)

The major flaw in this mainstream
dialogue is what is called a “fallacy of composition.” The typical textbook
example of a fallacy of composition is the football game where you can see better
if you stand up, and then conclude that everyone would see better if everyone
stood up. Wrong! If everyone stands up, then no one can see better, and all are
worse off. They all are looking at the micro level, which is individual Social
Security participants, rather than looking at the macro level, the entire
population.

To understand what’s fundamentally
wrong at the macro (big picture, top down) level, you first have to understand
that participating in Social Security is functionally the same as buying a
government bond. Let me explain. With the current Social Security program, you
give the government your dollars now, and it gives you back dollars later. This
is exactly what happens when you buy a government bond (or put your money in a
savings account). You give the government your dollars now and you get dollars
back later plus any interest.

Yes, one might turn out to be a better
investment and give you a higher return, but apart from the rate of return,
they are very much the same. (Now that you know this, you are way ahead of
Congress, by the way.)

Steve Moore

Now you are ready to read about the
conversation I had several years back with Steve Moore, then head of economics at
the CATO institute, now a CNBC regular and a longtime supporter of privatizing
Social Security. Steve came down to Florida to speak about Social Security at
one of my conferences. He gave a talk that called for letting people put their
money in the stock market rather than making Social Security payments,
contending that they will be better off over time when they retire. Also, he
argued that a one-time increase in the government budget deficit will be both
well worth it and probably “paid down” over time in the expansion to follow, as
all that money going into stocks will help the economy grow and prosper.

At that point I led off the question
and answer session.

Warren: “Steve, giving the government your money now in the form of
Social Security taxes and getting it back later, is functionally the same as
buying a government bond, where you give the government money now, and it gives
it back to you later. The only difference is the return that seniors will get.”

Steve: “OK, but with government bonds, you get a higher return than
with Social Security, which only pays your money back at 2% interest. Social
Security is a bad investment for individuals.”

Warren: “OK, I’ll get to the investment aspect later, but let me
continue. Under your privatization proposal, the government would reduce Social
Security payments and the employees would put that money into the stock market.”

Steve: “Yes, about $100 per month, and only into approved, high quality
stocks.”

Warren: “OK and the U.S. Treasury would have to issue and sell
additional securities to cover the reduced revenues.”

Steve: “Yes, and it would also be reducing Social Security payments
down the road.”

Warren: “Right. So to continue with my point, the employees buying the
stock buy them from someone else, so all the stocks do is change hands. No new
money goes into the economy.”

Steve: “Right.”

Warren: “And the people who sold the stock then have the money from the
sale which is the money that buys the government bonds.”

Steve: “Yes, you can think of it that way.”

Warren: “So what has happened is that the employees stopped buying into
Social Security, which we agree, was functionally the same as buying a
government bond, and instead they bought stocks. And other people sold their
stocks and bought the newly-issued government bonds. So looking at it from the
macro level, all that happened is that some stocks changed hands and some bonds
changed hands. Total stocks outstanding and total bonds outstanding, if you
count Social Security as a bond, remained about the same. And so this should
have no influence on the economy or total savings, or anything else apart from
generating transactions costs?”

Steve: “Yes, I suppose you can look at it that way, but I look at it as
privatizing, and I believe people can invest their money better than government
can.”

Warren: “Ok, but you agree that the amount of stocks held by the public
hasn’t changed, so with this proposal, nothing changes for the economy as a
whole.”

Steve: “But it does change things for Social Security participants.”

Warren: “Yes, with exactly the opposite change for others. And none of this
has even been discussed by Congress or any mainstream economist? It seems you have
an ideological bias toward privatization rhetoric, rather than the substance of
the proposal.”

Steve: “I like it because I believe in privatization. I believe that
you can invest your money better than government can.”

With that I’ll let Steve have the last
word here. The proposal in no way changes the number of shares of stock or
which stocks the American public would hold for investment. So at the macro
level, it is not the case of allowing the nation to “invest better than the
government can.” And Steve knows that, but it doesn’t matter - he continues to
peddle the same illogical story he knows is illogical. And he gets no criticism
from the media apart from the misguided discussion as to whether stocks are a
better investment than Social Security, will the bonds the government has to
sell take away savings that could be used for investment, if the government
risks its solvency by going even deeper into debt and all the other such
nonsense we’re calling innocent frauds.

Unfortunately, the deadly innocent
frauds continuously compound and obscure any chance for legitimate analysis. And
it gets worse! The ‘intergenerational’ story continues something like this:
“The problem is that 30 years from now there will be a lot more retired people
and proportionately fewer workers (which is true), and the Social Security
trust fund will run out of money (as if a number in a trust fund is an actual
constraint on the government’s ability to spend…silly, but they believe it). So
to solve the problem, we need to figure out a way to be able to provide seniors
with enough money to pay for the goods and services they will need.” With this
last statement it all goes bad. They assume that the real problem of fewer
workers and more retirees, which is also known as the “dependency ratio,” can
be solved by making sure the retirees have sufficient funds to buy what they
need.

Let’s look at it this way: 50 years
from now when there is one person left working and 300 million retired people
(I exaggerate to make the point), that guy is going to be pretty busy since
he’ll have to grow all the food, build and maintain all the buildings, do the
laundry, take care of all medical needs, produce the TV shows, etc. etc. etc. What
we need to do is make sure that those 300 million retired people have the funds
to pay him??? I don’t think so! This problem obviously isn’t about money.

What we need to do is make sure that
the one guy working is smart enough and productive enough and has enough
capital goods and software to be able to get it all done, or else those retirees
are in serious trouble, no matter how much money they might have. So the real
problem is, if the remaining workers aren’t sufficiently productive, there will
be a general shortage of goods and services. More “money to spend” will only
drive up prices and not somehow create more goods and services. The mainstream
story deteriorates further as it continues: “Therefore, government needs to cut
spending or increase taxes today, to accumulate the funds for tomorrow’s expenditures.”
By now I trust you know this is ridiculous and evident that the deadly innocent
frauds are hard at work to undermine our well-being and the next generation’s
standard of living as well.

We know our government neither has nor
doesn’t have dollars. It spends by changing numbers up in our bank accounts and
taxes by changing numbers down in our bank accounts. And raising taxes serves
to lower our spending power, not to give the government anything to spend.

It’s OK if spending is too high,
causing the economy to “overheat” (if we have too much spending power for what’s
for sale in that big department store called the economy). But if that’s not the
case, and in fact, spending is falling far short of what’s needed to buy what’s
offered for sale at full employment levels of output, raising taxes and taking
away our spending power only makes things that much worse.

And the story gets even worse. Any
mainstream economist will agree that there pretty much isn’t anything in the
way of real goods we can produce today that will be useful 50 years from now.
They go on to say that the only thing we can do for our descendants that far
into the future, is to do our best to make sure they have the knowledge and
technology to help them meet their future demands. The irony is that in order to
somehow “save” public funds for the future, what we do is cut back on expenditures
today, which does nothing but set our economy back and cause the growth of
output and employment to decline. And worse yet, the great disappointment is
that the first thing our misguided leaders cut back on is education - the one
thing that the mainstream agrees should be done that actually helps our children
50 years down the road.

Should our policy makers ever actually
get a handle on how the monetary system functions, they would realize that the
issue is social equity, and possibly inflation, but never government solvency.
They would realize that if they want seniors to have more income at any time,
it’s a simple matter of raising benefits, and that the real question is, what level
of real resource consumption do we want to provide for our seniors? How much food
do we want to allocate to them? How much housing? Clothing? Electricity?
Gasoline? Medical services? These are the real issues, and yes, giving seniors
more of those goods and services means less for us.

The amount of goods and services we
allocate to seniors is the real cost to us, not the actual payments, which are
nothing more than numbers in bank accounts. And if our leaders were concerned
about the future, they would support the types of education they thought would
be most valuable for that purpose. They don’t understand the monetary system,
though, and won’t see it the “right way around” until they do understand it.

Meanwhile, the deadly innocent fraud
of Social Security takes its toll on both our present and our future well-being.

Deadly Innocent Fraud #5

The
trade deficit is an unsustainable imbalance that takes away jobs and output.

FACTS: IMPORTS ARE
REAL BENEFITS AND EXPORTS ARE REAL COSTS. TRADE DEFICITS DIRECTLY IMPROVE OUR
STANDARD OF LIVING. JOBS ARE LOST BECAUSE TAXES ARE TOO HIGH FOR A GIVEN LEVEL
OF GOVERNMENT SPENDING, NOT BECAUSE OF IMPORTS.

By now you might suspect that, once
again, the mainstream has it all backwards, including the trade issue. To get
on track with the trade issue, always remember this: In economics, it’s better
to receive than to give. Therefore, as taught in 1styear economics classes: Imports
are real benefits. Exports are real costs.

In other words, going to work to produce
real goods and services to export for someone else to consume does you no economic
good at all, unless you get to import and consume the real goods and services
others produce in return. Put more succinctly: The real wealth of a nation is
all it produces and keeps for itself, plus all it imports, minus what it must
export.

A trade deficit, in fact, increases
our real standard of living.

How can it be any other way? So, the
higher the trade deficit the better. The mainstream economists, politicians,
and media all have the trade issue completely backwards. Sad but true.

To further make the point: If, for
example, General MacArthur had proclaimed after World War II that since Japan
had lost the war, they would be required to send the U.S. 2 million cars a year
and get nothing in return, the result would have been a major international
uproar about U.S. exploitation of conquered enemies. We would have been accused
of fostering a repeat of the aftermath of World War I, wherein the allies
demanded reparations from Germany which were presumably so high and exploitive
that they caused World War II. Well, MacArthur did not order that, yet for over
60 years, Japan has, in fact, been sending us about 2 million cars per year,
and we have been sending them little or nothing. And, surprisingly, they think
that this means they are winning the “trade war,” and we think it means that we
are losing it. We have the cars, and they have the bank statement from the Fed
showing which account their dollars are in.

Same with China - they think that they
are winning because they keep our stores full of their products and get nothing
in return, apart from that bank statement from the Fed. And our leaders agree
and think we are losing. This is madness on a grand scale

Now take a fresh look at the headlines
and commentary we see and hear daily:

- The
U.S. is “suffering” from a trade deficit.

- The
trade deficit is an unsustainable “imbalance.”

- The
U.S. is losing jobs to China.

- Like a
drunken sailor, the U.S. is borrowing from abroad to fund its spending habits,
leaving the bill to our children, as we deplete our national savings.

I’ve heard it all, and it’s all total nonsense.
We are benefiting IMMENSELY from the trade deficit. The rest of the world has
been sending us hundreds of billions of dollars’ worth of real goods and
services in excess of what we send to them. They get to produce and export, and
we get to import and consume. Is this an unsustainable imbalance that we need to
fix? Why would we want to end it? As long as they want to send us goods and
services without demanding any goods and services in return, why should we not
be able to take them?

There is no reason, apart from a
complete misunderstanding of our monetary system by our leaders that has turned
a massive real benefit into a nightmare of domestic unemployment. Recall from
the previous innocent frauds, the U.S. can ALWAYS support domestic output and sustain
domestic full employment with fiscal policy (tax cuts and/or govt. spending), even
when China, or any other nation, decides to send us real goods and services
that displace our industries previously doing that work. All we have to do is
keep American spending power high enough to be able to buy BOTH what foreigners
want to sell us AND all the goods and services that we can produce ourselves at
full employment levels. Yes, jobs may be lost in one or more industries. But
with the right fiscal policy, there will always be sufficient domestic spending
power to be able to employ those willing and able to work, producing other goods
and services for our private and public consumption. In fact, up until
recently, unemployment remained relatively low even as our trade deficit went
ever higher.

So what about all the noise about the
U.S. borrowing from abroad like a drunken sailor to fund our spending habits?
Also not true! We are not dependent on China to buy our securities or in any
way fund our spending. Here’s what’s really going on: Domestic credit creation
is funding foreign savings. What does this mean? Let’s look at an example of a
typical transaction. Assume you live in the U.S. and decide to buy a car made
in China. You go to a U.S. bank, get accepted for a loan and spend the funds on
the car. You exchanged the borrowed funds for the car, the Chinese car company
has a deposit in the bank and the bank has a loan to you and a deposit
belonging to the Chinese car company on their books. First, all parties are
“happy.” You would rather have the car than the funds, or you would not have
bought it, so you are happy. The Chinese car company would rather have the
funds than the car, or they would not have sold it, so they are happy. The bank
wants loans and deposits, or it wouldn’t have made the loan, so it’s happy

There is no “imbalance.” Everyone is
sitting fat and happy. They all got exactly what they wanted. The bank has a
loan and a deposit, so they are happy and in balance. The Chinese car company
has the $U.S. deposit they want as savings, so they are happy and in balance.
And you have the car you want and a car payment you agreed to, so you are happy
and in balance as well. Everyone is happy with what they have at that point in
time.

And domestic credit creation - the
bank loan - has funded the Chinese desire to hold a $U.S. deposit at the bank
which we also call savings. Where’s the “foreign capital?” There isn’t any! The
entire notion that the U.S. is somehow dependent on foreign capital is
inapplicable. Instead, it’s the foreigners who are dependent on our domestic
credit creation process to fund their desire to save $U.S. financial assets.
It’s all a case of domestic credit funding foreign savings. We are not
dependent on foreign savings for funding anything.

Again, it’s our spreadsheet and if
they want to save our dollars, they have to play in our sandbox. And what options
do foreign savers have for their dollar deposits?

They can do nothing, or they can buy
other financial assets from willing sellers or they can buy real goods and
services from willing sellers. And when they do that at market prices, again,
both parties are happy. The buyers get what they want - real goods and
services, other financial assets, etc. The sellers get what they want - the dollar
deposit. No imbalances are possible. And there is not even the remotest possibility
of U.S. dependency on foreign capital, as there is no foreign capital involved anywhere
in this process.

Deadly Innocent Fraud #6:

We need
savings to provide the funds for investment.

FACT: INVESTMENT
ADDS TO SAVINGS.

Second to last but not the least, this
innocent fraud undermines our entire economy, as it diverts real resources away
from the real sectors to the financial sector, with results in real investment
being directed in a manner totally divorced from public purpose. In fact, it’s
my guess that this deadly innocent fraud might be draining over 20% annually
from useful output and employment - a staggering statistic, unmatched in human history.
And it directly leads the type of financial crisis we’ve been going through.

It begins with what’s called “the
paradox of thrift” in the economics textbooks, which goes something like this:
In our economy, spending must equal all income, including profits, for the output
of the economy to get sold. (Think about that for a moment to make sure you’ve
got it before moving on.)

If anyone attempts to save by spending
less than his income, at least one other person must make up for that by
spending more than his own income, or else the output of the economy won’t get
sold.

Unsold output means excess inventories,
and the low sales means production and employment cuts, and thus less total
income. And that shortfall of income is equal to the amount not spent by the person
trying to save. Think of it as the person who’s trying to save (by not spending
his income) losing his job, and then not getting any income, because his
employer can’t sell all the output.

So the paradox is, “decisions to save
by not spending income result in less income and no new net savings.”

Likewise, decisions to spend more than
one’s income by going into debt cause incomes to rise and can drive real
investment and savings. Consider this extreme example to make the point.
Suppose everyone ordered a new pluggable hybrid car from our domestic auto
industry. Because the industry can’t currently produce that many cars, they
would hire us, and borrow to pay us to first build the new factories to meet
the new demand. That means we’d all be working on new plants and equipment -
capital goods - and getting paid. But there would not yet be anything to buy,
so we would necessarily be “saving” our money for the day the new cars roll off
the new assembly lines. The decision to spend on new cars in this case results
in less spending and more savings. And funds spent on the production of the
capital goods, which constitute real investment, leads to an equal amount of
savings.

I like to say it this way:
“SAVINGS IS THE ACCOUNTING RECORD OF INVESTMENT.”

Professor Basil Moore

I had this discussion with a Professor
Basil Moore in 1996 at a conference in New Hampshire, and he asked if he could use
that expression in a book he wanted to write. I’m pleased to report the book
with that name has been published and I’ve heard it’s a good read. (I’m waiting
for my autographed copy.)

Unfortunately, Congress, the media and
mainstream economists get this all wrong, and somehow conclude that we need
more savings so that there will be funding for investment. What seems to make
perfect sense at the micro level is again totally wrong at the macro level.

JUST AS LOANS CREATE DEPOSITS IN THE
BANKING SYSTEM; IT IS INVESTMENT THAT CREATES SAVINGS.

So what do our leaders do in their
infinite wisdom when investment falls, usually, because of low spending? They invariably
decide “we need more savings so there will be more money for investment.” (And
I’ve never heard a single objection from any mainstream economist.) To
accomplish this Congress uses the tax structure to create tax-advantaged savings
incentives, such as pension funds, IRA’s and all sorts of tax-advantaged
institutions that accumulate reserves on a tax deferred basis. Predictably, all
that these incentives do is remove aggregate demand (spending power). They
function to keep us from spending our money to buy our output, which slows the
economy and introduces the need for private sector credit expansion and public
sector deficit spending just to get us back to even.

This is why the seemingly-enormous
deficits turn out not to be as inflationary as they might otherwise be.

In fact it’s the Congressionally-engineered
tax incentives to reduce our spending (called “demand leakages”) that cut deeply
into our spending power, meaning that the government needs to run higher
deficits to keep us at full employment.

Ironically, it’s the same Congressmen
pushing the tax advantaged savings programs, thinking we need more savings to
have money for investment, that are categorically opposed to federal deficit
spending.

And, of course, it gets even worse! The
massive pools of funds (created by this deadly innocent fraud #6, that savings
are needed for investment) also need to be managed for the further purpose of
compounding the monetary savings for the beneficiaries of the future. The problem
is that, in addition to requiring higher federal deficits, the trillions of
dollars compounding in these funds are the support base of the dreaded
financial sector. They employ thousands of pension fund managers whipping around
vast sums of dollars, which are largely subject to government regulation. For
the most part, that means investing in publicly-traded stocks, rated bonds and
some diversification to other strategies such as hedge funds and passive
commodity strategies. And, feeding on these “bloated whales,” are the inevitable
sharks - the thousands of financial professionals in the brokerage, banking and
financial management industries who owe their existence to this 6th deadly
innocent fraud.

Deadly Innocent Fraud #7

It’s a
bad thing that higher deficits today mean higher taxes tomorrow.

FACT: I AGREE - THE
INNOCENT FRAUD IS THAT IT’S A BAD THING, WHEN IN FACT IT’S A GOOD THING!!!

Your reward for getting this far is
that you already know the truth about this most common criticism of government deficits.
I saved this for last so you would have all the tools to make a decisive and
informed response.

First, why does government tax? Not to
get money, but instead to take away our spending power if it thinks we have too
much spending power and it’s causing inflation.

Why are we running higher deficits
today? Because the “department store” has a lot of unsold goods and services in
it, unemployment is high and output is lower than capacity.

The government is buying what it wants
and we don’t have enough after-tax spending power to buy what’s left over. So we
cut taxes and maybe increase government spending to increase spending power and
help clear the shelves of unsold goods and services.

And why would we ever increase taxes?
Not for the government to get money to spend - we know it doesn’t work that way.
We would increase taxes only when our spending power is too high, and
unemployment has gotten very low, and the shelves have gone empty due to our
excess spending power, and our available spending power is causing unwanted
inflation.

So the statement “Higher deficits
today mean higher taxes tomorrow” in fact is saying, “Higher deficits today,
when unemployment is high, will cause unemployment to go down to the point we
need to raise taxes to cool down a booming economy.” Agreed!

Part II: The Age
of Discovery

I was born in the Manchester Memorial
Hospital on September 18, 1949. My parents are Daniel and Muriel Mosler, and I
was the oldest of three children. My brother Seth was born in 1951 and my
sister Susan in 1955. We lived in an apartment on West Middle Turnpike before
moving to a three-bedroom house at 47 Marion Drive in 1960. We lived there for
about three years before selling the house and moving to a nearby rental due to
financial difficulties. I attended Wadell School and then Buckley elementary
school after we moved. I went to Illing Jr. High School and then Manchester
High School where my father had also graduated in 1937.

We were what seemed to be a typical
middle class Manchester family. My father worked as an accountant, tried
managing a liquor store, sold life insurance and did tax preparation. My mother
was an RN (registered nurse) and worked nights at Manchester Memorial Hospital.

I suspect I contracted my car disease
at the age of maybe 8. I recall taking apart old lawn mowers and using the
parts to make motorbikes and go-carts, using bolts and often wooden parts.
Getting anything welded was a luxury outside of the family budget. And I might still
be able to name on sight every U.S. car built from 1955 to 1975. I recall
sitting on the sidewalk of the main road through town with my brother naming
the cars as they drove by.

I had a variety of odd jobs in high
school, including teaching kids to swim at a day camp, working at a local department
store, mowing lawns and shoveling snow for the neighbors.

I got through high school with average
grades, but my teachers always told me that I had “potential” if I would only apply
myself. This was the standard assessment of the majority of American high
school students, though I did do reasonably well on my SAT’s, with a low 700
score in math and a low 600 score in the verbal section.

After I graduated from high school in
1967 (about 30TH out of a class of about 575), I attended the
University of Connecticut, a public university, primarily because it only cost $300
per year for residents. Because I had accepted a $1,000 scholarship and a slide
rule from a local organization to study engineering, I spent my first two years
as an engineering student. I then switched my major to economics, and received
a B.A. in 1971, which also happened to be the year things got bad enough for
President Nixon to implement price and wage controls and take the United States
off the gold standard internationally. We were in a recession, inflation had
hit 3%, and France had tried to take their gold home from Fort Knox.

When I graduated in 1971, I
experienced a recession first hand. I recall one job interview at National Cash
Register that began with this friendly but resigned greeting from the hiring manager:
“I don’t know why you and I are here. We’re laying people off.”

I spent the next eighteen months
working odd jobs, including a stint as a pool attendant in Miami Beach, where I
put out mats and umbrellas for 25-cent tips and a $20 a week (GROSS) salary. To
get by with paying me that little, the management also let me sleep in the
storage room.

I finally got a real job in 1973, when
I got a haircut and re-applied for a job at the Savings Bank of Manchester in
my home town. (They told me after I was hired I was turned down the first time
because my hair was too long.)

I started in the bank’s personal loan
department, where my first responsibility was to collect delinquent loans. Paul
Coupe, the department head, handed me the collection books and added with a
smile, “there’s gold in them there books.”

Once a loan was delinquent, my job was
to figure out how to get the money back. That could mean anything from phone calls
to trying to get the borrower to make his payments to repossessing the car or other
collateral and selling it for as much as possible. Collection methods also
included home visits, using the legal system to secure legal judgments against the
debtors and attaching bank accounts or garnishing wages to directly collect the
money owed to the bank.

I quickly realized that this was where
the rubber meets the road for the entire credit system. Without enforcement,
there is no extension of credit. Loans were only as good as the ability to
collect them. Years later, I would recognize this was also true of the currency
itself, and that the value of the dollar was only as good as the federal government’s
ability to enforce tax collection. (More on this later.)

After a year of doing collections,
Paul gave me lending authority for loans up to $1,000. This was a
responsibility I took very seriously. I was now responsible for lending other
people’s money, which for me was a far greater responsibility than lending my
own money.

I remember having ongoing discussions
with Paul on what could be called the “theory of lending” and the “logic of banking.”
The idea is that anyone can make loans so selectively that there will never be
any losses. But the trick is to make loans where money might be lost, but where
the odds were high enough so the interest the bank was making on the loans more
than made up for the small amount of expected losses.

My collections experience brought home
the nuances of what made loans go bad. It also made very clear that even with very
high lending standards regarding the borrower’s income, time on the job, home
equity and past payment records, many other things could go wrong that could
cause a borrower who looked like a very good risk at the outset to default. Job
losses, illnesses, personal problems, car accidents and death all had some
probability of taking place some percentage of the time.

I understood that the lender would try
and quantify all these risks before a loan was extended, and attempt to
determine if the interest rate the bank intended to charge would be sufficient to
cover the losses from loans that went bad, and still provide a good return to
the bank.

Yes, we could tighten standards and
reduce losses, but we would make very few loans and not be profitable. If we were
too lax with our standards, we would make a lot more loans but the losses would
eat up the profits. The answer was somewhere in between. The right answer to
running a profitable bank, in the lending arena at least, lays somewhere in the
middle of the two extremes of having standards that are too high and standards
that are too low. As Paul used to tell me, when reviewing my loans that had
gone bad, “If you aren’t taking some losses, you’re costing the bank money.”

I currently own a “buy here pay here”
used car lot. All of our borrowers are subprime or less, and I make the lending
decisions myself. Of every 100 new loans, 3 or 4 seem to go bad and cost me a
few dollars after the car is repossessed and resold. And I still wonder with
each application if I’m being too tight or too lax. After 40 years, the basic
concepts of determining credit-worthiness still seem to hold.

Not long after I had been given
lending authority, the bank foreclosed on a small (maybe 50 rooms) motel in
downtown Manchester named Piano’s, after the former owners. Paul sent me to
manage it. The goal was to improve its operations sufficiently to get it sold
as soon as possible, at as good a price as possible. We were in the banking
business, and didn’t want to be in the motel business.

When I arrived at the motel, I noticed
that all the light bulbs were missing. “Welcome to what happens when borrowers
go bad!” I thought to myself. The first thing I did was arrange to get some
basic maintenance done to the motel, including some new light bulbs. I also
began formulating a strategy to increase room revenues, so that a potential
purchaser could see some actual cash flow, increasing the likelihood we could
sell it.

First, I calculated the total monthly
fixed expenses, assuming a 50% occupancy rate. Then, I did the math backwards,
and calculated that if we could rent out half the rooms at $49 per week, we would
break even. This was only $7 per day, a significantly lower rate than the going
rate of $15 per day for most motels at the time. But once we had half the motel
filled up at the relatively low weekly rate and all our expenses were covered,
then the daily rents from the rest of the rooms would make us profitable. There
seemed to be no risk to this strategy, but I needed to get approval from
higher-ups at the bank.

I made a presentation to our bank’s
Vice President, Bill Johnson, where I outlined my strategy. Bill readily gave
me the go-ahead. I put my first ad in the local paper announcing the new weekly
rate, and within days the $49 per week rooms started filling up. I was pleasantly
surprised and pleased that there was a demand for my new offering. As it turned
out, quite a few respectable local professional people would occasionally have
“domestic issues” and need a place to stay for a few weeks.

We got those rooms filled, and the
motel started showing some profit. We soon sold it for a decent price and made
a little profit on the original loan.

Not long after that, the president of
the bank retired, and Bill Johnson took his job. Bill had been running the
securities portfolio. I think Bill liked the way I had handled the motel foreclosure,
so he promoted me to “investment officer” and I became the portfolio manager.
While the portfolio was very small - only $5 million in stocks and $5 million
in short-term investments - the scale of the responsibility seemed very large to
me at the time. My previous lending authority had been only $5,000, and that
had seemed large. Now I was responsible for $10 million of the bank’s money.

My hands were shaking when I made my
first call to purchase a $500,000 Certificate of Deposit for the bank. Don Chardenierre
of the Merrill Lynch office in Hartford was on the other end of the phone. I
introduced myself to Don and asked for an interest rate offering from Merrill
Lynch on the half a million dollars I wished to invest. Very politely, Don told
me that the minimum investment they handled was $1 million, but that he would
see what they could do for me. I thanked him and hung up the phone, now feeling
very small!

Managing the bank’s stocks meant
attending meetings with our financial advisor, Ted Ladd of Standish, Ayers, and
Woods in Boston. Bill, now our bank president and one of the finest human
beings anyone can know, would take me to the meetings at the an old inn in Sturbridge,
Mass., to meet with Ted and discuss our portfolio of equities, as well as
external factors including the economy and the financial markets. We would also
discuss possible changes in our holdings. Since Ted was given full discretion to
manage the $5 million in our stock portfolio, there wasn’t much for me to do in
that half of the job.

But the other half of my job -
managing our $5 million in short-term investments - was entirely managed in
house, and I was free to come up with ideas to make the best of that money.

We had been keeping most of the $5
million in bank CDs (certificates of deposit) with maturities of about 6
months. At that time, we were paying 5.25% in interest to the depositors in our
bank’s savings accounts. This rate was fixed by law, and so all savings banks
were paying that rate to their depositors.

Unfortunately, we could only earn
about 4% on our short-term investments in CDs, as that’s where the Federal
Reserve was setting short-term interest rates.

This seemed like an odd situation to
me. During one of our regular management meetings at the bank, I suggested that
instead of buying short-term CDs that paid us a 4% interest rate, we should simply
go to another savings bank, and open a regular savings account that paid the
5.25% they were required by law to pay.

“We just put our money in a regular
savings account at another savings bank at the 5.25% rate and let them worry about
it!” I said in the meeting.

“Why would we help another bank by
doing that?” asked one of the more senior executives. My mentor and bank president
Bill Johnson responded, “What will they do with the money, except take a loss?”

The skeptical executive had no answer
to Bill’s question, and his silence caused more than a little amusement at the
meeting. The idea was approved.

The next day, I got in the car and
started visiting other banks, trying to open a savings account for our bank.
Several banks wouldn’t accept our money. I remember a couple branch managers
who were nearly in tears when their bosses turned down their request to accept
our money for deposit into their bank.

“First they tell me to get deposits,
and then you come in with $100,000, and they won’t take it. What do they want
me to do?” one of the branch managers moaned.

After a few days I finally managed to
get my banks extra few hundred thousand dollars invested in savings accounts at
other savings banks at the 5.25% rate--1.25% higher than what we would have
received from CDs. (I asked for the free toasters the other banks were giving
away at the time to anyone opening a new deposit, but not one of the banks
would give me one!)

By now, after my experiences with the
motel turnaround, and the improvement in the bank’s return on short-term investments,
I had a clear sense that I had an aptitude for the logic of finance. I had the
ability to, now and then, see opportunities that others had overlooked.

About this time, there was a new type
of mortgage-backed security, called a GNMA (pronounced “Ginny May”) pass through.
You could buy a GNMA pass through, and it would pay interest just like a
mortgage investment. But you weren’t getting a mortgage payment from a single
property; you were buying a participation in a large pool of individual
mortgages and getting your share of all the payments. And all the payments were
fully guaranteed by the U.S. government, so there was no default risk. But,
since the interest rates paid were a lot lower than the mortgage rates we were
getting locally, it didn’t make sense for our bank to invest in them.

However, I discovered something else
was happening with GNMA securities. The Wall Street dealers were offering them for
sale for future delivery dates.  In other words, you could buy and sell them
for delivery in the future. For instance, in March you could buy GNMA securities
for delivery in March, but you could also buy them for delivery in June or even
September. The price for these securities would be determined in March, but you
didn’t receive them or pay for them until the agreed-upon future delivery date.
Also, the market prices to purchase the same GNMA security for delivery in
March, June, or September differed. Something about this new kind of security
and the price differential based upon the different time of delivery intrigued
me. I started looking at the prices for the different delivery dates, trying to
understand what they were based on. I somehow noticed that the prices were such
that if I bought the GNMA’s for March delivery, and at the same time sold them
for June delivery, my actual earnings for that three month period would be
higher than if I bought a 3-month CD for the bank, or put the funds in a
savings account at another bank. Additionally, I discovered I could borrow the
money to pay for the GNMA securities for the same 3 months at an even lower
rate.

So I went back to our management team
with a proposal. We could buy $1 million in GNMA’s for March delivery, and at
the same time sell them for June delivery, and the prices were such that we
would earn a 5.5% annual rate on our money for that 90 day period. And, at the
same time, our bank could borrow $1 million at only 4.5% for the same 90 days
by using that same $1 million in GNMA’s to secure our borrowing.

This meant a locked-in profit for the
bank - we borrowed at 4.5% and made 5.5% on the transaction. The management team
approved the trades, and I booked my first fixed income mortgage-backed
securities arbitrage profit. That’s what the term “arbitrage” means - the simultaneous
purchase and sale of the same securities, commodities or foreign exchange in different
markets to profit from unequal prices.”

That Friday night, at about 8 pm, I
got a call at home from Jim Saxon from Salomon Brothers in New York City. He
inquired, “Hi, I’m in a late sales meeting, and we are discussing your GNMA
trade. Can you tell me one more time how it works?”

At the time, Salomon Brothers was the
top Wall Street Fixed Income House. (Years later in the 1990’s, they ran into a
small market manipulation issue with U.S. Treasury and, as a result, were taken
over by Citibank.) I found out later from three of their senior managers that
during their high flying years in the 1980’s, it was my ideas that had been
instrumental in getting them named managing directors. These three managing
directors went on to form a hedge fund, called Long Term Capital, where they
developed their own ideas, this time with Nobel Prize winning economists.

In those early 1970’s when I worked
there, the Savings Bank of Manchester was one of those thousands of dull, boring
savings banks that paid 5.25% to their depositors and financed homes with 8%,
30-year mortgages. We got to work at 8:30 am, and left to play golf (Or
softball. My shoulder still isn’t quite right from trying to throw someone out
at the plate from the outfield) around 4 pm. And in 1972, with a U.S. population
of just over 200 million, these plain, dumb, boring savings banks financed 2.6
million new housing starts, with no secondary markets, no futures markets, and
very modestly paid employees (I started at $140 per week, and had worked my way
up to $200 per week as an investment officer).

Today, with a population of over 300
million, a massive financial sector, untold financial innovations, and
unlimited financial resources and liquidity, if we manage to get 2 million housing
starts a year, it’s proclaimed an unsustainable bubble. More on that kind of
“progress” later in this book.

Wall Street

George Weisse was a broker at Bache
and Company, and he was one of the brokers on my list to call when we needed to
do any transactions. We never did much actual business, but we did have several
discussions of financial markets and trading strategies. George was doing very
well with his brokerage business that focused on buying and selling public
utility stocks.

In 1975, George was looking for an
assistant who could both help him with his utility stock business and at the same
time cover what were called second tier institutions for Bache’s other
products, including bonds and other fixed income securities. He offered me a
starting salary of $15,000 a year, which was roughly 50% more than the bank was
paying, and a chance to make more if successful. That year, I joined Bache as
George’s assistant. I remember getting into work one day with George talking on
the phone while lying on the floor. I asked what happened. He said his back
went out again. So I asked how it happened. He told me that he had been
carrying big rocks up to his house from the river behind it. Turns out he had a
bad back and this would happen on a regular basis. When it wasn’t carrying
rocks it was playing tennis or something like that. I got my SEC Series 7 license
soon after I joined the firm, which qualified me to sell securities for life.

George was making serious money with
his institutional equity sales, and was very, very good at what he did. He left
Bache about a year after I got there, cutting himself a much better deal with
Shearson. I stayed at Bache in Hartford, where I was now getting full commissions
on all the clients for any business I could do. In my first month I made $5,000
which was a very high number for me. It was 1976. Life was good.

And then I got another job offer. Jay
Pomerenze offered me a job on Wall Street with Bankers Trust Co. as an Assistant
Vice President of Sales and Trading of GNMA securities. Jay was the GNMA trader
at Bankers. I knew him from my Savings Bank of Manchester days. My primary
contact at Bankers was Bill Lovern, who introduced me to Jay when I had become
interested in GNMA’s. Most memorable on my first trip to Wall St. was lunch at
Kabuki where Bill took me for a new thing called sushi. Bill left Bankers for
Weeden while I was still at Bache, and I had stayed in touch with Jay.

Jay said the job paid $30,000 a year.
I said I was making $60,000 where I was ($5,000 the first month times 12 = $60,000).
He said he’d go and talk to the higher-ups and got back to me with a $45,000
offer. I accepted.

I moved from Hartford, Conn. where I
had been paying $125 a month for rent to New York City, where my one bedroom at
80th and York on the 20th floor was $525 a month. Federal taxes were 50%, and
in New York City, state and local taxes took away about another 20%. I was taking
home only about $350 a week from my gross pay of maybe $900. After rent, I was
about back to where I was at the savings bank.

At Bankers, Jay and I pioneered the
use of a variety of the new derivative products. These financial products were
being introduced on the Chicago and New York futures markets at the time. They
included new futures market contracts, various kinds of options and regular
securities traded for future delivery dates.

I also recall discussions from those
days that trace the history of my understanding of monetary operations. At some
point while I was at Bankers, the Fed raised the reserve requirements. Our
trading manager, Alan Rogers, said he hoped the Fed didn’t just give the banks
the money. He said the money supply was too high and the Fed needed to take
some of it away. I thought about that for a moment and told him the Fed had to
supply the money, as it couldn’t come from anywhere else. The banking system
was just a T account with assets and liabilities, and you can’t just take away
the assets. There is no such thing. He then said, “Well, there’s $300 billion sloshing
around in Europe, and they could use some of that.” I replied that those were
all T accounts as well and it wasn’t a possibility, as a matter of accounting.
The point here is I must have been thinking about that quite a bit back then,
maybe in discussions with Jay and others, to have been able to use it with
confidence in a relatively high-level discussion with the trading manager on
the trading desk.

Well, Erich Heiniman, senior economist
at Morgan Stanley, came out with the same position as Alan, which was published
in the Wall St. Journal. My future partner, Cliff Viner, a portfolio manager at
Phoenix Mutual Insurance in Hartford, directed me to the Morgan Stanley
editorial that argued, as Alan did, that the Fed should not give the banks the
funds this time. I told Cliff how it worked and why the Fed would necessarily
“give” the banks the funds. Cliff called Morgan Stanley who gave him a double
talk answer. I gave Cliff a response to that answer and he called them back.
They then told Cliff that they retracted their position. The Fed, of course,
added the reserves the next day with open market operations. The alternative would
have been bank overdrafts, which carry a higher interest rate than the Fed’s
fed funds target, but are loans from the Fed nonetheless, though booked somewhat
differently.

There are other examples as well. I
recall Alan wondering where the $2 billion to buy the Treasury 2-year notes
would come from. I answered it’s the same money that they deficit spend that
buys the Treasury notes. I don’t know how or why I came to know that type of
thing back then, when no one else seemed to get it, including members of the
Fed and Treasury.

In 1978, one of my clients, Colonial
Mortgage, defaulted on an obligation to buy GNMA securities which I had sold to
them. When the time had come to pay for the securities and take deliveries,
they didn’t have the money, and the price of the securities had gone down. So our
trading desk sold them at a loss. This default occurred shortly after the
credit department of Bankers Trust had sent a senior credit team to visit
Colonial Mortgage, and after extensive analysis, had established their credit
lines.

As an Assistant Vice President of
Sales and Trading, my responsibilities were not to determine the credit-worthiness
of my clients. In fact, I wasn’t allowed to do that. That was the job of the
credit department. My job was to help Bankers Trust make money by utilizing the
credit lines that had been, after long analysis, established for that purpose.

Even though I had nothing to do with
determining the credit-worthiness of Colonial Mortgage, I was assigned blame for
their default. This was a first-hand view of corporate bureaucracy in action,
as the various managers, including those on the credit team who had failed to
accurately assess Colonial’s credit worthiness, scrambled to avoid any responsibility.
No one came to my defense. Enough said about this up-close look at institutional
structure at work.

All along I was contributing quite a
bit to the overall profits of the trading desk. One February, Jay was on
vacation and I sat in to do the trading. February was a 28-day month that year,
and month end was on a weekend.

Interest rates were something like
12%, and I knew GNMA securities paid interest based on a 30-day month even when
there were only 28 days in the month. So I started making very tight markets
for the sales force. In fact, I would offer to buy or sell GNMA’s at the same
price, with no spread at all.

However, my bid (the price I would buy
at) was for the Friday before month end, and my offered price was for the
Monday following month end. The extra 2 days interest I would get for buying on
Friday and then selling on Monday at the same price was over $500 per million
dollars’ worth of securities.

Because of the knowledge of the 2
days’ free interest, our sales force had the highest bids and lowest offers of
anyone on Wall St. - we did a lot of business, and made a lot of money.

When the February trading results were
announced in March, Alan Rodgers calmly read the results for each trader. For perspective,
back then, making over $1 million a year in total profits for the entire
trading floor was considered to be very good. Alan announced each trader
individually: “2-year note trader - up $10,000, ten-year note trader - down
$5,000….” And then he said: “GNMA - up $432,000, but that’s just “carry.” Turns
out he was dismissive of the money I had made (not to mention the market share
gained) because it wasn’t made taking “real market risk.”

When bonus time came around, things
took another turn for the worse for me. My sales manager, Rich Molere, told me
I wasn’t getting a bonus because my business was mainly GNMA securities, and
Bankers Trust was a “Government Bond Shop.” I suggested he take a look at the
accounts I was assigned from them. He looked through the list and realized that
all of the accounts were mortgage bankers and savings & loan banks that did
only GNMA business and none would ever do any bond business. So he said he’d
give me some “bond accounts” to see what I could do.

The first was Chase Advisors, run by
Bill Burke, who became a good friend of mine. The first thing I did was set up a
“research meeting” where I visited them with Alan Lerner, our chief economist.
We made a presentation to their group.

That went well, and the next day,
Chase “rewarded” us with an order for a few 2-year Treasury notes that made us
about a $200 profit, if that. Rich congratulated me and said that that was more
like it, that that was what he wanted to see.

The other account was Larry Burke at
Oppenheimer. He was an aggressive government bond trader, and we started doing
quite a bit of bond business (not all that profitable but certainly very
active). The problem was that our trading desk wasn’t quite ready for dealing
with a “real” trader, so we missed a lot of business another firm would have done.
More interesting was the day Larry called me and said he had to get out of
about $10 million long bonds right away. I knew our long bond trader, Paul Lagrande,
wasn’t in a position to make a competitive bid for that large a position. I
suggested to Larry that he let Paul do the best he could in the broker’s market
and just take a small commission for helping him get the bonds sold. Larry
agreed, and I told Paul he had an order to sell Larry’s bonds the best he
could, and take a $1500 markup, regardless of what price he got.

Well, Paul didn’t get it. He had never
been given an order to sell bonds like that. He got defensive and said,
“There’s a 99 1⁄2 bid on the screen, but I can’t pay that.” I said I knew
that and that I wasn’t asking him to buy the bonds from Larry in advance. I
explained that he just had to sell $10 million bonds to the brokers at the best
price he could get. After a couple of back and forths, he sold the bonds to the
brokers markets at a good price, then said “Now what do I do? I’m short!” I
said, “You buy the bonds from Larry at the prices you sold them less the $1500,
which is your profit.” He wrote the tickets and was all smiles…and so was Larry.
It was a win/win situation.

I had proven to Rich that I could sell
government bonds for Bankers Trust. I also knew that that and $10 would get me
a cup of coffee. Fortunately, another opportunity was developing for me. Buzz
Newton, head of the Corporate Bond Department at William Blair and Company in
Chicago, asked me to start a fixed income arbitrage department as part of his
corporate bond department. Buzz was one of my clients at Bankers Trust, and
though he rarely did a trade with me, he liked my ideas and saw the value of
bringing me in to implement those ideas. I told Buzz I had a pretty good job at
Bankers Trust. He explained that the position at Wm Blair and Co. had no
salary. Instead, I would get a retail payout of 30% of my net profits. A very
short time later I was in Chicago working at Blair, Chicago

Moving to Chicago from New York City
was like taking off tight shoes. You don’t realize they’re tight until after
you take them off. NYC might have 5 dry cleaners on every block and Chicago
only one, but you only need one. It was the same with the people. Chicago
allows people to be nicer, friendlier, with little or no edge. In NYC there’s
often aggression for no further purpose. It seemed an argumentative way of life
compared to Chicago.

While I was at Wm Blair, I took on two
partners: Justin Adams from the NYC office of First Boston, Corp. and Cliff Viner
from Phoenix Mutual in Hartford, Connecticut. Justin was a GNMA trader at First
Boston, working with Larry Fink, who went on to start Blackrock, which is
probably the most successful asset management firm in the world. I got to know
Justin while I was working at Bankers Trust. I filled in for Jay trading GNMA’s
when he was away on vacation. I remember at one point during the month of
February, GNMA 81⁄4% securities trading for March delivery were 3⁄4
of a point more expensive than they were for April delivery. It was very tempting
to sell them short for March and at the same time buy them for April delivery,
hoping that the spread would narrow before it was time to deliver the bonds I
had sold for March delivery. The problem was that there were only a few weeks left
for prices to “normalize” and there was the risk the spread would widen further
and I’d be forced to close out my positions at a loss. While looking at the
spread, it dawned on me to calculate how much I’d lose if I put the trade on
and, worst case, simply failed to deliver the bonds I had sold short for March
and didn’t cover that fail until I took delivery of bonds I had bought for
April delivery. It turned out that the loss would be only 5/8ths of a point. So
selling March and buying April at a 3⁄4 spread, with a ‘worst case’ of
losing only 5/8 points if I failed to deliver the entire month of March, would
still be a 1/8 point profit. And there was a fair chance that the spread would narrow
some time before that and the actual profit would be larger. So I took this
idea to Alan Rogers, the trading manager, and he rejected the idea, saying “Bankers
Trust is not going to put on a position knowing it’s going to fail to deliver
on time.” I tried to point out I didn’t know we would fail, and in fact, I was hoping
the spreads would narrow before that because the profit would be several times
larger. Additionally, failing to deliver was not only “not a crime,” the
counterparty taking delivery actually preferred that you failed to deliver, as
he then didn’t have to pay for the bonds until you did deliver, and earned very
high rates of interest on his money while waiting for you to deliver. In fact,
Jay and I had made hundreds of thousands of dollars due to people failing to deliver
to us. Alan would hear none of it. I then called Justin at First Boston and
explained the trade, and why I wasn’t allowed to do it. He immediately put
several hundred million of it on for First Boston and had a very good month,
providing liquidity for real investors and narrower spreads for them as well.

I knew Cliff from my time at Bache working
for George Weiss. Cliff worked upstairs in the same building, managing 5 equity
portfolios for Phoenix Mutual in Hartford. George knew Cliff and had me cover
him for bonds. The first idea I showed Cliff was a UTC convertible bond that
was selling only 1/32 above its actual conversion value. Cliff gave me an order
to buy them at a price equal to the conversion value, which never did happen.

At Wm Blair, we were a very effective
team. Justin and I worked on the trading strategies, while Cliff covered the handful
of accounts that paid us commissions to piggyback onto our ideas. For the next
five years, we were responsible for maybe 80% of Wm Blair’s profits, which
increased every year we were there, and we made lots of money for our clients as
well.

A lot of those early profits came from
arbitraging the newly-introduced futures contracts and the cash markets. We were
among the first to grasp the concept of imbedded options in the various futures
contracts. To give you an example of what all that means, when the new 10-year
Treasury note futures contract was announced in the early 80’s, the first thing
we did was attempt to figure out what the correct prices for the futures contracts
should be. The futures contract was a set of rules that told you what prices
you would pay if you bought a futures contract, kept it until it expired and
then took delivery of any of the eligible 10-year Treasury securities. And, as
they still do today, every three months the U.S. Treasury would auction off
billions of brand new 10-year Treasury notes. Knowing the current price of the
eligible 10-year U.S. Treasury securities, one could calculate what the prices
should be for the new 10-year Treasury futures contracts.

But there was another element. The new
futures contracts would be for March, June, September, and December delivery dates,
like all the other futures contracts. The first contract was for March delivery
and the second for June delivery. However, what was different for March and
June delivery was that the new 10-year note that would be auctioned in May
would obviously not be deliverable in March, before it was issued, but would be
eligible to be delivered in June. Additionally, at that time, each new 10-year
note that the U.S. Treasury auctioned came at a higher yield than the older
Treasury securities. This meant that the June contract should be expected to
trade at a lower price than the March contract, because the new “cheaper”
Treasury note to be auctioned in May would affect the June futures contract but
not the March futures contract.

A week or so before the contract
opened, the CBT (Chicago Board of Trade) conducted “practice trades” for the
floor brokers. I inquired as to what the futures prices were for March and June
for the practice trading session. Turned out that the March contract was
trading at 100, and the June at 1001⁄2. We calculated that with the March
contract at 100, June was only worth 991⁄2. Seems that the floor traders
doing the practice trades did not realize that the new 10-year notes to be
auctioned in June would lower the value of the June contract, but not the March
contract, which reflected the value of the current 10-year note.

With the opening of the new contract
in just a few days, we started discussing which broker to use. About that time,
we got a call from a Vince Ciaglia, who worked at a firm called Stotler. We’d
never done much business with Vince, until this call. Vince started asking me
what I thought the March/June spread should be. He wasn’t sure and started
asking what we thought the new 10-year Treasury note that would be deliverable in
June might do to the spread. I told him that we were looking at the same thing
and asked if he wanted our business for this trade in return for talking
exclusively to us. He agreed. The next discussion with Vince was about which
floor broker to use (the floor broker was the person down at the exchange who
did the actual buying and selling in what was called the “futures pit,” back
before electronic trading) so that when our order was entered, the floor broker
wouldn’t scare the other traders. Vince had the ideal broker named Les. Les was
a broker who worked in both the bean pit and the bond pit, and the last time he
was in the bond pit, he had put his order in backwards and then had to go back
in and trade his way out of his mistake.

When the 10-year futures market
started trading on May 3, 1982, the first quotes had June about 1/8% higher
than March. Not as good as we’d hoped for, but still a very long way from being
1⁄2% under March, which was what we thought, was fair value. So we sent
Les into the pit to buy 5,000 March contracts and sell 5,000 June contracts at
the spread of 1/8%. Each contract represented $100,000 worth of Treasury
securities, so this was a $500,000 order. Back then, a position like that could
be “safely” taken on with less than $5 million in available capital.

Les went into the pit and came out a
few minutes later, reporting all 5,000 done at our price. Seems the other
brokers thought he was making another mistake, that he was supposed to be
selling March and buying June based on where they thought prices should be from
practice trading. So thinking there was easy money again coming their way, they
filled his order out of their own trading accounts and then waited for him to
discover his error and come back into the pit to try and reverse what he’d done
and take another loss. Ten minutes later, when Les still hadn’t come back, they
suspected the worst - that he wasn’t coming back, and they started scrambling
to cover their positions as best as they could. I don’t know what happened
after that, except that over the next few weeks we made almost $3 million (back
when that was a lot of money) as the March/June spread did indeed gravitate to
what we had calculated as “fair value.” It was a very good month for Wm Blair
and Company.

On a look back, those five years I
spent at William Blair in Chicago were my formative years. (Ned Janotta, the
Senior Partner at Blair, remains one of the most astute, honorable and
personable individuals one could possibly encounter, fortunately for me, as
this next episode illustrates.) What could have been an unceremonious end
instead turned out to be the beginning of the best of times for both Wm Blair
and Company and for me as well.

It was early 1980. We had purchased
30-year U.S, Treasury bonds and sold the June delivery, 30-year bond futures
contracts, which had become very expensive relative to the prices we were
paying for the deliverable bonds. (The CBT had initiated a 30-year bond contract
several years before it introduced the 10-year note futures in 1982) The prices
of the bonds and the bond futures were such that if we held the bonds until
June and then delivered them we would make a reasonably large profit. We knew
of no reason why the spreads were so wide. It was like buying eggs from a
farmer and selling them to the store and making a large profit. However,
shortly after we put this trade on our books, the market changed dramatically, for
unknown reasons, and it was suddenly possible to put the same trade in at
prices that represented an even larger profit.

While this is good news if you have
more “dry powder” to add to your position, at the same time the position we
already had in place was showing a substantial, $1 million loss. Let me give
you an analogy to try to explain how this works. Suppose you are offered a
free, $10 bill if you agree to come and pick it up in 30 days, and you take it.
Then the next day things change and they are offering free $20 bill in 30 days.
Sounds good, but now your first contract, to pick up the $10 bill in 30 days
actually represents a loss of $10, because why would anyone take your $10 bill
when there are currently $20 bills being offered? And so if you wanted to get
out of your obligation to get a free $10 in 30 days, you would have to pay
someone $10, so he could get the same $20 the other guy is offering. And, the
real problem is that if you decide to stay with your contract to get a free $10
bill in 30 days, you have to now post $10 with the exchange so that if you take
a hike and they have to liquidate your contract they don’t have to take the $10
loss.

I immediately sat down with Ned,
explaining that the position was to make us a $1 million profit when we
delivered our bonds in June, but that the prices had changed, and we had to
either meet a $1 million margin call, or close out the position and sustain a
$1 million loss. He asked what would happen if we waited until June. I
explained that we would get both our originally contracted $1 million profit
and $1 million in margin money back. I also said there was no guarantee the position
wouldn’t move further against us, but in any case by the June delivery date
we’d get it all back plus $1 million.

Ned made the call, said he agreed with
our plan to stay with the trade, and the meeting was over. Other Wall Street trading
desks were not as fortunate. There were stories of their managers forcing them
to exit their positions immediately at substantial losses.

Not long after that meeting, the
prices of gold and silver collapsed, as did the Treasury note futures we had
sold short, our margin money was returned and our expected profits were realized.
And we also discovered what was happening behind the scenes. The billionaire
Hunt brothers (back when that was a lot of money) had been buying the same
Treasury futures we had been selling short with the profits they were making
buying silver and driving prices up to almost $60/oz. (today silver is still
under $20/oz.). That is what had caused our temporary “mark to market” loss.
And it was the collapse of the gold and silver prices that forced the Hunt
brothers to liquidate both their silver positions and their bond futures
positions, and return our trade to profitability. What made this all the more interesting
was how that happened. It seems the owners of the COMEX, the NY exchange where
the silver futures were traded, sold short for their personal accounts when
silver went over $50/oz., and then drastically raised margin requirements for
the Hunts, forcing them to liquidate and lose billions (and restoring our
profits) as the price of silver dropped to under $10/oz. And this was all
perfectly legal at the time.

In 1982, Justin, Cliff and I were
aware the markets were large enough for us to manage more capital without
hurting our returns for our investors. It didn’t make sense to do that within
the legal structure of a broker-dealer like William Blair.

Ned helped us to raise more capital
and keep the business separate from William Blair. We formed our own company, Illinois
Income Investors, (later shortened to III), with Wm Blair and Company as one of
our partners. Illinois Income Investors specialized in fixed income arbitrage,
utilizing both actual securities and related derivative products, with a market
neutral/0 duration strategy. That meant we promised no interest rate exposure,
rates going up or down were not supposed to be a factor in the level of
profits. We were paid 35% of the profits but no fixed management fees.

Over the next fifteen years, we
continued the success we’d had at William Blair and Company. Including the time
at Blair, we established a 20-year track record (from 1978 to 1997) with only
one losing month, a drop of a tenth of one percent on a mark to market that reversed
the next month, and no losing trades that any of us can recall. III was ranked Number
One in the world for the highest risk-adjusted spreads by Managed Account
Reports through 1997. When I stepped down, Cliff Viner took control of about
$3.5 billion in capital and $35 billion in assets. The 1996 drama with the
Tokyo Futures exchange along with philosophical differences with a new partner
told me it was a good time to take a break.

The designation for the September 1996
futures contract for the 10-year JGB’s (Japanese government bonds) was JBU6,
which at one time was to be the title of this book, before the term “innocent
fraud” was coined. This time, again for some unknown reason, the JBU6 (the
September futures contract) was, to me, mispriced. But this time it was on the Tokyo
exchange, this time it was too cheap, this time there was a large interest rate
swap market and this time we had over $3 billion under management, bwtwalom
(back when that was a lot of money). Slowly, over the months leading up to September,
we and our clients began to buy the JBU6 and pay fixed on 7 to 10-year yen
labor swaps. Without going into a lot more detail, it’s enough to understand
that paying a fixed rate on a swap was roughly equivalent to selling real bonds
short.

So we were using the cheap futures
market to buy bonds and sell them at what we thought was a higher price via the
interest rate swap market. The position got very large, approaching 7,500
contracts, which represented over $7 billion worth of bonds (yes, bwtwalom). Around
then, we noticed that we had contracted to take delivery of more of the
cheapest to deliver JGB’s than the government of Japan had issued.

That added a new dimension. If we took
delivery, the other side would have to give us something, and if the cheapest bonds
to deliver weren’t available, they would be forced to deliver more expensive bonds
to us, which meant higher profits. And, if supply of that more expensive bond
was exhausted, they would be forced to deliver an even more expensive bond.

While this looked very attractive to
us, the nagging question was why anyone would be selling us the futures
contracts at what looked to be very low prices.

Additionally, at this point, the
September futures contract also looked cheap vs. the December ‘06 and March ‘07
futures prices, so we also bought September and sold December and March futures.
But the futures remained cheap and we kept adding to our position. We got up to
over 14,000 contracts for III and for our AVM clients before the delivery date,
and the futures were still cheap.

Astounding! I had our repo trader
check to see if the bonds we were expecting to be delivered were available to
be borrowed. I was guessing the dealers who had sold short to us were maybe going
to deliver borrowed bonds to us. But no, there were still bonds to be borrowed
- and borrowed relatively cheaply. So we borrowed the bonds ourselves to make
sure that no one did an end run around us, and tried to deliver borrowed bonds,
not that it mattered all that much if they did, but I wasn’t keen on taking any
chances at this point.

The next step was finding a dealer who
we could use to take delivery. I was hoping to find one who had the same trade
on so we could take delivery on the combined positions. I found Craig Foster at
Credit Suisse in Tokyo.

He was long about 7,000 contracts and
had a similar trade on. Perfect! One last piece, if we were to take delivery of
what was now some $20 billion of JGB’s (still a lot of money), we needed to borrow
the money to pay for them. Craig made the call to Switzerland and relayed the
good news; he had a $20 billion line from his home office.

We were bullet proof.

When the notice day came, the day when
the other side has to tell you what bonds they are delivering to you, we were
notified that the other side was mostly going to deliver to us the cheapest
bonds possible. Fine, except that there weren’t that many. We considered the
possibility that they somehow had gotten extra bonds that didn’t previously
exist from the Bank of Japan. Then we started getting the calls asking us to lend
them the bonds they needed to deliver to us and wanted to know what price we
would charge them. This was madness!

They had to have the bonds. They were
committed to deliver them to us, and the penalty for failing to deliver was
absolute dismissal from the yen bond markets and unknown fines from the Bank of
Japan for disrupting their financial system. We were on the good side, buying Japans
bonds via their futures market. They like people to buy their bonds. It was the
other side that had the explaining to do. They had been selling billions of
Japan’s bonds short and didn’t even have any to deliver. The Bank of Japan did
some serious wrist slapping over that.

Well, we did lend them the bonds, but
at a price. Since we did need the dealers to stay in business, we let them out
at a price of about half of what they probably would have charged us had the
situation been reversed (maybe a lot less than half). Perhaps we should have
been tougher on them, but we walked away with about $150 million in profits for
our side and went on record as having engineered the largest futures delivery
of all time, last I checked.

Italian Epiphany

I now backtrack to the early 1990’s,
to conclude this narrative leading up to the seven deadly innocent frauds. It
was then that circumstances led me to the next level of understanding of the actual
functioning of a currency.

Back then, it was the government of
Italy, rather than the United States, which was in crisis. Professor Rudi
Dornbusch, an influential academic economist at MIT, insisted that Italy was on
the verge of default because their debt-to-GDP ratio exceeded 110% and the lira
interest rate was higher than the Italian growth rate.

Things were so bad that Italian
Government Securities denominated in lira yielded about 2% more than the cost of
borrowing the lira from the banks. The perceived risk of owning Italian
government bonds was so high that you could buy Italian government securities
at about 14%, and borrow the lira to pay for them from the banks at only about
12% for the full term of the securities. This was a free lunch of 2%, raw meat
for any bond desk like mine, apart from just one thing; the perceived risk of
default by the Italian government. There was easy money to be made, but only if
you knew for sure that the Italian government wouldn’t default.

The “Free Lunch” possibility totally
preoccupied me. The reward for turning this into a risk free spread was
immense. So I started brainstorming the issue with my partners. We knew no nation
had ever defaulted on its own currency when it was not legally convertible into
gold or anything else.

There was a time when nations issued
securities that were convertible into gold. That era, however, ended for good
in 1971 when President Nixon took us off the gold standard internationally (the
same year I got my BA from U-Conn) and we entered the era of floating exchange
rates and non-convertible currencies.

While some people still think that the
America dollar is backed by the gold in Fort Knox, which is not the case. If
you take a $10 bill to the Treasury Department and demand gold for it, they
won’t give it to you because they simply are not legally allowed to do so, even
if they wanted to. They will give you two $5 bills or ten $1 bills, but forget
about getting any gold.

Historically, government defaults came
only with the likes of gold standards, fixed exchange rates, external currency debt,
and indexed domestic debt. But why was that? The answer generally given was “because
they can always print the money.” Fair enough, but there were no defaults (lots
of inflation but no defaults) and no one ever did “print the money,” so I
needed a better reason before committing millions of our investors funds.

A few days later when talking to our
research analyst, Tom Shulke, it came to me. I said, “Tom, if we buy securities
from the Fed or Treasury, functionally there is no difference. We send the
funds to the same place (the Federal Reserve) and we own the same thing, a
Treasury security, which is nothing more than account at the Fed that pays
interest.”

So functionally it has to all be the
same. Yet presumably the Treasury sells securities to fund expenditures, while
when the Fed sells securities, it’s a “reserve drain” to “offset operating factors”
and manage the fed funds rate. Yet they have to be functionally the same - it’s
all just a glorified reserve drain!

Many of my colleagues in the world of
hedge fund management were intrigued by the profit potential that might exist
in the 2% free lunch that the Government of Italy was offering us. Maurice
Samuels, then a portfolio manager at Harvard Management, immediately got on
board, and set up meetings for us in Rome with officials of the Italian government
to discuss these issues.

Maurice and I were soon on a plane to
Rome. Shortly after landing, we were meeting with Professor Luigi Spaventa, a
senior official of the Italian Government’s Treasury Department. (I recall
telling Maurice to duck as we entered the room. He looked up and started to
laugh. The opening was maybe twenty feet high. “That’s so you could enter this room
in Roman times carrying a spear,” he replied.)

Professor Spaventa was sitting behind
an elegant desk. He was wearing a three-piece suit, and smoking one of those curled
pipes. The image of the great English economist John Maynard Keynes, whose work
was at the center of much economic policy discussion for so many years, came to
mind.

Professor Spaventa was Italian, but he
spoke English with a British accent, furthering the Keynesian imagery.

After we exchanged greetings, I opened
with a question that got right to the core of the reason for our trip.

“Professor Spaventa, this is a
rhetorical question, but why is Italy issuing Treasury securities? Is it to get
lira to spend, or is it to prevent the lira interbank rate falling to zero from
your target rate of 12%?” I could tell that Professor Spaventa was at first puzzled
by the questions. He was probably expecting us to question when we would get
our withholding tax back. The Italian Treasury Department was way behind on
making their payments. They had only two people assigned to the task of
remitting the withheld funds to foreign holders of Italian bonds, and one of
these two was a woman on maternity leave.

Professor Spaventa took a minute to
collect his thoughts.

When he answered my question, he
revealed an understanding of monetary operations we had rarely seen from
Treasury officials in any country. “No,” he replied. “The interbank rate would
only fall to 1⁄2%, NOT 0%, as we pay 1⁄2% interest on reserves.”
His insightful response was everything we had hoped for. Here was a Finance Minister
who actually understood monetary operations and reserve accounting! (Note also
that only recently has the U.S. Fed been allowed to pay interest on reserves as
a tool for hitting their interest rate target)

I said nothing, giving him more time
to consider the question. A few seconds later he jumped up out of his seat proclaiming
“Yes! And the International Monetary Fund is making us act pro cyclical!” My
question had led to the realization that the IMF was making the Italian
Government tighten policy due to a default risk that did not exist.

Our meeting, originally planned to
last for only twenty minutes, went on for two hours. The good Professor began inviting
his associates in nearby offices to join us to hear the good news, and
instantly the cappuccino was flowing like water. The dark cloud of default had
been lifted. This was time for celebration!

A week later, an announcement came out
of the Italian Ministry of Finance regarding all Italian government bonds - “No
extraordinary measures will be taken. All payments will be made on time.” We
and our clients were later told we were the largest holders of Italian lira
denominated bonds outside of Italy, and managed a pretty good few years with
that position.

Italy did not default, nor was there
ever any solvency risk. Insolvency is never an issue with nonconvertible
currency and floating exchange rates. We knew that, and now the Italian Government
also understood this and was unlikely to “do something stupid,” such as proclaiming
a default when there was no actual financial reason to do so. Over the next few
years, our funds and happy clients made well over $100 million in profits on
these transactions, and we may have saved the Italian Government as well. The
awareness of how currencies function operationally inspired this book and
hopefully will soon save the world from itself.

As I continued to consider the ramifications
of government solvency not being an issue, the ongoing debate over the U.S. budget
deficit was raging. It was the early 1990’s, and the recession had driven the
deficit up to 5% of GDP (deficits are traditionally thought of as a percent of
GDP when comparing one nation with another, and one year to another, to adjust
for the different sized economies).

Gloom and doom were everywhere. News anchor
David Brinkley suggested that the nation needed to declare bankruptcy and get
it over with. Ross Perot’s popularity was on the rise with his fiscal
responsibility theme. Perot actually became one of the most successful 3rd
party candidates in history by promising to balance the budget. (His rising
popularity was cut short only when he claimed the Viet Cong were stalking his
daughter’s wedding in Texas.)

With my new understanding, I was
keenly aware of the risks to the welfare of our nation. I knew that the larger
federal deficits were fixing the broken economy, but I watched helplessly as
our mainstream leaders and the entire media clamored for fiscal responsibility
(lower deficits) and were prolonging the agony.

It was then that I began conceiving
the academic paper that would become Soft Currency Economics. I discussed it
with my previous boss, Ned Janotta, at William Blair.

He suggested I talk to Donald Rumsfeld
(his college roommate, close friend and business associate), who personally
knew many of the country’s leading economists, about getting it published.
Shortly after, I got together with “Rummy” for an hour during his only opening
that week. We met in the steam room of the Chicago Racquet Club and discussed
fiscal and monetary policy. He sent me to Art Laffer who took on the project
and assigned Mark McNary to co-author, research and edit the manuscript, which
was completed in 1993.

Soft Currency Economics remains at the
head of the “mandatory readings” list at www.moslereconomics.com where I keep a
running blog. It describes the workings of the monetary system, what’s gone
wrong and how gold standard rhetoric has been carried over to a nonconvertible currency
with a floating exchange rate and is undermining national prosperity.

Part III: Public
Purpose

Functions of government are those that
best serve the community by being done collectively. These include: The military,
the legal system, international relations, police protection, public health
(and disease control), public funding for education, strategic stockpiles,
maintaining the payments system, and the prevention of “races to the bottom” between
the states, including environmental standards, enforcement standards,
regulatory standards and judicial standards.

What has made the American economy the
envy of the world has been that people working for a living make sufficient
take-home pay in order to be able to purchase the majority of the goods and
services they desire and are produced. And what American business does is compete
for those dollars with the goods and services they offer for sale. Those
businesses that produce goods and services desired by consumers are often rewarded
with high profits, while those that fail fall by the wayside.

The responsibility of the federal
government is to keep taxes low enough so that people have the dollars to spend
to be able to purchase the goods and services they prefer from the businesses
of their choice.

Today, unfortunately, we are being
grossly overtaxed for the current level of government spending, as evidenced by
the high level of unemployment and the high level of excess capacity in general.
People working for a living are getting squeezed, as they are no longer taking
home a large enough pay check to cover their mortgage payments, car payments
and various routine expenses, never mind any extra luxuries.

TO
ADDRESS THE CURRENT FINANCIAL CRISIS AND ECONOMIC COLLAPSE, I RECOMMEND A
NUMBER OF PROPOSALS IN THE PAGES AHEAD.

A Payroll Tax Holiday

I recommend that an immediate “payroll
tax holiday” be declared whereby the U.S. Treasury makes all FICA, Medicare and
other federal payroll tax deductions for all employees and employers. This
proposal will increase the take-home pay of a couple making a combined $100,000
per year by over $650 per month, restoring their ability to make their mortgage
payments, meet their routine expenses, and even do a little shopping. People
with money to spend will immediately lead to a pickup in business sales, which will
quickly result in millions of new jobs to serve the increased demand for goods
and services. And people able to make their mortgage and loan payments is exactly
what the banking system needs most to quickly return to health, not government
funding that can only keeps them limping along with loans that continue to
default. The only difference between a good loan and a bad loan is whether or not
the borrower can make his payment.

Revenue sharing

My second proposal is to give the U.S.
state governments an immediate, unrestricted $150 billion of revenue sharing on
a per capita basis (about $500 per capita). Most of the states are in dire straits
as the recession has cut into their normal revenue sources. By pushing back
federal funds on a per capita basis, it will be “fair” to all and not
specifically “reward bad behavior.” This distribution will give the states the
immediate relief they need to sustain their essential services. As the economy
recovers, their revenues will increase to pre-recession levels and beyond.

National Service Jobs

The next recommendation of mine is to
fund an $8/hour national service job for anyone willing and able to work; this will
include child care, the current federal medical coverage and all of the other
standard benefits of federal employees.

This is a critical step to sustain
growth and foster price stability. This provides a transition from unemployment
to private sector employment. Businesses tend to resist hiring the unemployed,
and especially the long-term unemployed. This national service job provides a
transition from unemployment to employment, and, as the economy recovers (due
to my first two proposals), businesses will hire from this pool of labor to meet
their needs for more workers.

Universal Health Care Coverage

My proposal regarding health care is
to give everyone over the age of 18 a bank account that has, perhaps, $5,000 in
it, to be used for medical purposes. $1,000 is for preventative measures and
$4,000 for all other medical expenses. At the end of each year, any unspent
funds remaining of the $4,000 portion are paid to that individual as a “cash
rebate.” Anything above $5,000 would be covered by a form of Medicare. There would
be no restrictions on purchasing private insurance policies. This proposal
provides for universal health care, maximizes choice, employs competitive market
forces to minimize costs, frees up physician time previously spent in
discussion with insurance companies, rewards “good behavior” and reduces
insurance company participation.

This will greatly reduce demands on
the medical system, substantially increasing the supply of available
doctor/patient time and makes sure all Americans have health care. To ensure
preventative measures are taken, the year-end rebate can be dependent, for
example, on the individual getting an annual checkup. And though it is
federally funded, it can be administered by the states, which could also set
standards and requirements.

There is no economic school of thought
that would suggest health care should be what’s called a “marginal cost of
production”, which means that it is bad for the economy and our entire standard of living
to have business pay for health care. This proposal eliminates that problem for
the American economy in a way that provides health care for everyone, saves
real costs, puts the right incentives in place, promotes choice and directs
competitive forces to work in favor of public purpose.

Proposals for the Monetary System

First, the Federal Reserve should
immediately lend to its member banks on an unsecured basis, rather than
demanding collateral for its loans. Demanding collateral is both redundant and
obstructive. It is redundant because member banks can already raise government-insured
deposits and issue government-insured securities in unlimited quantities without
pledging specific collateral to secure those borrowings. In return, banks are
subject to strict government regulation regarding what they can do with those
insured funds they raise, and the government continuously examines and
supervises all of its member banks for compliance. With the government already
insuring bank deposits and making sure only solvent banks continue to function,
the government is taking no additional risk by allowing the Federal Reserve to
lend to its member banks on an unsecured basis. With the Federal Reserve
lending unsecured to its member banks, liquidity would immediately be
normalized and no longer be a factor contributing to the current financial
crisis or any future financial crisis.

Second, the government should also
remove the $250,000 cap on insured bank deposits, as well as remove regulations
pertaining to bank liquidity, at the same time that it allows the Federal Reserve
to lend unsecured to member banks. The Federal Reserve should lower the discount
rate to the fed funds rate (and, as above, remove the current collateral
requirements). The notion of a “penalty” rate is inapplicable with today’s
nonconvertible currency and floating exchange rate policy.

Third, an interbank market serves no
public purpose. It can be eliminated by having the Federal Reserve offer loans to
member banks for up to 6 months, with the FOMC (Federal Open Market Committee,
the collection of Fed officials who meet and vote on monetary policy) setting
the term structure of rates at its regular meetings. This would also replace
many of the various other lending facilities the FOMC has been experimenting
with.

Fourth, have the Treasury directly fund
the debt of the FHLB (Federal Home Loan Bank) and FNMA (the Federal National
Mortgage Association), the U.S. Federal housing agencies. This will reduce
their funding costs, and this savings will be directly passed on to qualifying home
buyers. There is no reason to give investors today’s excess funding costs currently
paid by those federal housing agencies when the full faith and credit of the US
government is backing them.

Fifth, have FNMA and the FHLB
“originate and hold” any mortgages they make, and thereby eliminate that
portion of the secondary mortgage market. With Treasury funding, secondary
markets do not serve public purpose.

Sixth, increase and vigorously enforce
mortgage fraud penalties with Federal agencies.

Strategic Stockpiles

When families live on remote farms,
for example, it makes sense to store perhaps a year or more of food for crop
failures and other potential disruptions of the food supply. However, families living
in cities, as a practical matter, instead can only save U.S. dollars. Unfortunately,
in the event of actual shortages of food and other strategic supplies, numbers
in bank accounts obviously will not do the trick. It is therefore a matter of
public purpose to insure that there are actual strategic reserves for emergency
consumption. Currently we have a strategic oil reserve. This should be extended
to stores of other necessities for the purpose of emergency consumption. The purpose
should not be to support special interest groups, but to provide the consumer
with real supplies of actual consumables for rainy days.

A Housing Proposal for the Financial
Crisis:

1) If the
owner of a house about to be foreclosed wants to remain in the house, he
notifies the government, which then buys the house during the foreclosure sale period
from the bank at the lower of fair market value or the remaining mortgage
balance.

2) The
government rents the house to the former owner at a fair market rent.

3) After
two years, the house is offered for sale and the former owner/renter has the
right of first refusal to buy it. While this requires a lot of direct
government involvement and expense, and while there is room for dishonesty at
many levels, it is far superior to any of the proposed plans regarding public
purpose, which includes:

a)
Keeping people in their homes via affordable rents;

b) Not
interfering with existing contract law for mortgage contracts;

c)
Minimizing government disruption of outcomes for mortgage backed securities
holders;

d) Minimizing
the moral hazard issue.

With this proposal, the foreclosure
process is allowed to function according to law, so no contracts are violated.
And renting to the former owner at a fair market rent is not a subsidy, nor is
the repurchase option at market price a subsidy.

How We Can All Benefit from the Trade Deficit

The current trade gap is a reflection
of the rest of the world’s desires to save U.S. financial assets. The only way
that the foreign sector can do this is by net exporting to the U.S. and keeping
U.S. dollars as some form of dollar financial assets (cash, securities, stocks,
etc.). So the trade deficit is not a matter of the U.S. being dependent on borrowing
offshore, as pundits proclaim daily, but a case of offshore investors desiring to
hold U.S. financial assets. To accomplish their savings desires, foreigners
vigorously compete in U.S. markets by selling at the lowest possible prices.
They go so far as to force down their own domestic wages and consumption in their
drive for “competitiveness,” all to our advantage. If they lose their desire to
hold U.S. dollars, they will either spend them here or not sell us products to
begin with, in which case that will mean a balanced trade position. While this process
could mean an adjustment in the foreign currency markets, it does NOT cause a
financial crisis for the U.S.

The trade deficit is a boon to the US.
There need not be a “jobs issue” associated with it. Appropriate fiscal policy
can always result in Americans having enough spending power to purchase both
our own full employment output and anything the foreign sector may wish to sell
us. The right fiscal policy works to optimize our output, employment and
standard of living, given any size trade gap.

Industries with Strategic Purpose

Our steel industry is an example of a
domestic industry with important national security considerations. Therefore, I
would suggest that rather than continuing with the general steel tariffs
recently implemented, defense contractors should be ordered to use only
domestic steel. This will ensure a domestic steel industry capable of meeting
our defense needs, with defense contractors paying a bit extra for domestically
produced steel, while at the same time lowering the price for non-strategic
steel consumption for general use. Using a Labor Buffer Stock to let Markets Decide
the

Optimum Deficit

To optimize output, substantially
reduce unemployment, promote price stability and use market forces to
immediately promote health-care insurance nationally, the government can offer
an $8 per hour job to anyone willing and able to work that includes full
federal health-care benefits. To execute this program, the government can first
inform its existing agencies that anyone hired at $8 per hour “doesn’t count” for
annual budget expenditures. Additionally, these agencies can advertise their
need for $8 per hour employees with the local government unemployment office,
where anyone willing and able to work can be dispatched to the available job
openings. This job will include full benefits, including health care, vacation,
etc. These positions will form a national labor “buffer stock” in the sense
that it will be expected that these employees will be prone to being hired away
by the private sector when the economy improves. As a buffer stock program,
this is highly countercyclical anti-inflationary in a recovery, and
anti-deflationary in a slowdown. Furthermore, it allows the market to determine
the government deficit, which automatically sets it at a near “neutral” level.
In addition to the direct benefits of more output from more workers, the
indirect benefits of full employment should be very high as well.

These include increased family
coherence, reduced domestic violence, less crime, and reduced incarcerations.
In particular, teen and minority employment should increase dramatically,
hopefully, substantially reducing the current costly levels of unemployment.

Interest Rates and Monetary Policy

It is the realm of the Federal Reserve
to decide the nation’s interest rates. I see every reason to keep the “risk
free” interest rate at a minimum, and let the market decide the subsequent credit
spreads as it assesses risk.

Since government securities function
to support interest rates, and not to finance expenditure, they are not
necessary for the operation of government. Therefore, I would instruct the Treasury
to immediately cease issuing securities longer than 90 days. This will serve to
lower long-term rates and support investment, including housing. Note, the
Treasury issuing long term securities and the Fed subsequently buying them, as
recently proposed, is functionally identical to the Treasury simply not issuing
those securities in the first place.

I would also instruct the Federal
Reserve to maintain a Japan like 0% fed funds rate. This is not inflationary
nor is it the cause of currency depreciation, as Japan has demonstrated for
over 10 years. Remember, for every $ borrowed in the banking system, there is a
$ saved. Therefore, changing rates shifts income from one group to another. The
net income effect is zero. Additionally, the non-government sector is a net
holder of government securities, which means there are that many more dollars
saved than borrowed. Lower interest rates mean lower interest income for the non-government
sector. Thus, it is only if the borrower’s propensity to consume is
substantially higher than that of savers does the effect of lower interest
rates become expansionary in any undesirable way. And history has shown this
never to be the case. Lower long term rates support investment, which
encourages productivity and growth. High risk-free interest rates support those
living off of interest payments (called rentiers), thereby reducing the size of
the labor force and consequently reducing real national output.

The Role of Government Securities

It is clear that government securities
are not needed to “fund” expenditures, as all spending is but the process of crediting
a private bank account at the Fed. Nor does the selling of government securities
remove wealth, as someone buying them takes funds from his bank account (which
is a U.S. financial asset) to pay for them, and receives a government security
(which is also a U.S. financial asset). Your net wealth is the same whether you
have $1 million in a bank account or a $1 million Treasury security. In fact, a
Treasury security is functionally nothing more than a time deposit at the Fed.

Nearly 20 years ago, Soft Currency
Economics was written to reveal that government securities function to support
interest rates, and not to fund expenditures as generally perceived. It goes
through the debits and credits of reserve accounting in detail, including an
explanation of how government, when the Fed and Treasury are considered
together, is best thought of as spending first, and then offering securities
for sale.

Government spending adds funds to
member bank reserve accounts. If Govt. securities are not offered for sale,
it’s not that government checks would bounce, but that interest rates would
remain at the interest rate paid on those reserve balances.

In the real world, we know this must
be true. Look at how Turkey functioned for over a decade - quadrillions of
liras of deficit spending, interest rate targets often at 100%, inflation nearly
the same, continuous currency depreciation and no confidence whatsoever. Yet
government “finance” in lira was never an issue. Government lira checks never
bounced.

If they had been relying on borrowing
from the markets to sustain spending, as the mainstream presumed they did, they
would have been shut down long ago. Same with Japan – over 200% total
government debt to GDP, 7% annual deficits, downgraded below Botswana, and yet
government yen checks never bounced, and 3-month government securities fund
near 0%. Again, clearly, funding is not the imperative.

The U.S. is often labeled “the world’s
largest debtor.” But what does it actually owe? For example, assume the U.S. government
bought a foreign car for $50,000. The government has the car, and a
non-resident has a U.S. dollar bank account with $50,000 in it, mirroring the
$50,000 his bank has in its account at the Fed that it received for the sale of
the car. The non-resident now decides that instead of the non-interest bearing
demand deposit, he’d rather have a $50,000 Treasury security, which he buys
from the government. Bottom line: the US government gets the car and the
non-resident holds the government security. Now what exactly does the U.S. government
owe? When the $50,000 security matures, all the government has promised is to
replace the security held at the Fed with a $50,000 (plus interest) credit to a
member bank reserve account at the Fed. One financial asset is exchanged for
another. The Fed exchanges an interest bearing financial asset (the security)
with a non-interest bearing asset. That is the ENTIRE obligation of the U.S.
government regarding its securities. That’s why debt outstanding in a government’s
currency of issue is never a solvency issue.

Children as an Investment Rather than an Expense

Anyone who pauses to think about it
will realize that our children are our fundamental real investment for the
future. It should be obvious to all that without children, there won’t be much
human life left in 100 years. However, our current institutional structure -
the tax code and other laws and incentives on the books - have made our
children an expense rather than an investment. And a lot of behavior most of us
would like to see not happen, including deficiencies in education, child
neglect and abuse and high rates of abortion, could be addressed by modifying
the incentives built into our financial system.

Public Purpose

For me, all federal public policy
begins and ends with public purpose. I begin with a brief list of the functions
of government, all of which comprise what can be called public infrastructure,
that in my estimation do serve public purpose and should be provisioned
accordingly.

The first is defense. It is my strong
belief that without adequate military defenses, the world’s democracies (a word
I’ll use for most forms of representative governments) are at risk of physical
invasion and domination by nations with dictatorships and other related forms
of totalitarianism. While democracies will move to defend themselves, in
today’s world, it is most often the dictatorships that move militarily to
attack other nations without the provocation of a military threat. Examples
include Pakistan threatening India, North Korea threatening not only South
Korea but others in the region, Russia supporting military actions against most
any western democracy, Israel under constant threat of attack by all the
region’s dictatorships and the Taliban attempting to take control of
Afghanistan and disrupt any attempt at establishing representative government.
It is evident to me that if the western democracies decided to abandon all
defense measures they would immediately become subject to hostile invasion on multiple
fronts. Therefore, there is a critical public purpose being served by
allocating real resources to national defense.

The next step is to set the objectives
of our defense effort. At one time this included “the ability to fight a
prolonged war on two fronts” much like the European and Pacific fronts of World
War II. Other objectives have included the ability to strike mostly anywhere in
the world within a certain number of hours with a force of a pre-determined
size, to maintain air superiority and to be able to deliver nuclear weapons
against the Soviet Union and other potentially hostile nations which can direct
nuclear weapons at the U.S. and, more recently, to have the capability of using
drones to assassinate hostile individuals remotely anywhere in the world.

These are all military objectives.
Some are general, some very specific. In the United States, they are ultimately
political choices. For me this means the President, as Commander in Chief,
submitting these types of high-level military objectives to Congress for
approval, and then working to achieve those objectives by proposing more
specific military options to accomplish our national goals.  The President
proposes objectives and what is needed to accomplish those objectives, and the
Congress reviews, debates, and modifies the objectives and proposals to meet
those objectives, and appropriates the resources it decides necessary to meet
what it decides best serves the nation’s military objectives.

Most of the world’s democracies (and
particularly those with a U.S. military presence) have, however, come to rely
on the assumption that the U.S. would ultimately defend them. Often, though not
always, this is through formal alliances. This ultimate reliance on the U.S. military
has resulted in these nations not allocating what would otherwise be
substantial portions of their real wealth to their national defense. One option
for addressing this issue would be to meet with the world’s democracies and
establish what a “fair contribution” to the U.S. defense effort would be for
these nations, and then go so far as to publish a “non-defense” pledge for
those who refuse to contribute their fair share of real goods and services to
the common defense.

The ‘right sized’ defense has
everything to do with actual defense needs, and nothing to do with the total
expenditures of dollars necessary to meet the nation’s defense needs. Nor need there
any mention of “how are we going to pay for it” as taxes function to regulate
aggregate demand and not to raise revenue per se. The way we, the current generation,
always “pay for I”’ is by the real resources - goods and services - that are
allocated to the military that could have remained in the private sector for
private consumption. That real cost includes all the people serving in the
military who could have been working and producing goods and services in the
private sector for private consumption. That includes everything from auto
workers to tennis instructors, lawyers, doctors, and stock brokers.

The “right size” and “right type” of
defense can change dramatically over relatively short periods of time. China’s capability
of shooting down satellites and Iranian medium range nuclear missiles that
could threaten our shipping are but two examples of how the advance of military
technology can very quickly make prior technologies instantly obsolete. Both objectives
and options must be under continuous review, and there can be no letup in
advancing new technologies to do all we can to stay on the leading edge of
military effectiveness.

About 10 years ago I was discussing
the military with a member of the Pentagon. He said that we needed to increase the
size of the military. I said that if we wanted to do that we should have done
it ten years ago (1990) when we were in a recession with high unemployment and
excess capacity in general. Back then, with all that excess capacity, a buildup
of the military would not have been taking as many productive resources away
from the private sector as it would have done during a period of full employment.
He responded, “Yes, but back then we couldn’t afford it, the nation was running
a budget deficit; while today with a budget surplus, we can afford it’.

This is completely backwards! The
government never has nor doesn’t have any dollars. The right amount of spending
has nothing to do with whether the budget is in surplus or deficit.

They use the monetary system which
provides no information for all their information.

Inflation!

OK, so the risk of running a deficit
that is too large is not insolvency - the government can’t go broke - but
excess aggregate demand (spending power) that can be inflationary.

While this is something I’ve never
seen in the U.S. in my 60-year lifetime, it is theoretically possible. But then
again, this can only happen if the government doesn’t limit its spending by the
prices it is willing to pay, and, instead, is willing to pay ever higher prices
even as it’s spending drives up those prices, as would probably be the case.

And now here is a good place to review
what I first wrote back in 1992 for Soft Currency Economics, which came out in
1993:

Inflation vs. Price Increases

Bottom line, the currency itself is a
public monopoly, which means the price level is necessarily a function of
prices paid by the government when it spends, and/or collateral demanded when
it lends. The last part means that if the Fed simply lent without limit and
without demanding collateral we would all borrow like crazy and drive prices to
the moon. Hence, bank assets need to be regulated because otherwise, with FDIC insured
deposits, bankers could and probably would borrow like crazy to pay themselves
unlimited salaries at taxpayer expense.

And that’s pretty much what happened
in the S & L crisis of the 1980’s, which also helped drive the Reagan boom
until it was discovered. Much like the subprime boom drove the Bush expansion
until it was discovered. So it now goes without saying that bank assets and
capital ratios need to be regulated.

But let’s return to the first part of
the statement - “the price level is a function of prices paid by govt. when it
spends.” What does this mean? It means that since the economy needs the
government spending to get the dollars it needs to pay taxes, the government
can, as a point of logic decide what it wants to pay for things, and the economy
has no choice but to sell to the government at the prices set by government in
order to get the dollars it needs to pay taxes, and save however many dollar
financial assets it wants to. Let me give you an extreme example of how this
works: Suppose the government said it wasn’t going to pay a penny more for
anything this year than it paid last year, and was going to leave taxes as they
are in any case. And then suppose this year all prices went up by more than
that. In that case, with its policy of not paying a penny more for anything,
government would decide that spending would go from last year’s $3.5 trillion
to 0. That would leave the private sector trillions of dollars short of the
funds it needs to pay the taxes. To get the funds needed to pay its taxes,
prices would start falling in the economy as people offered their unsold goods
and services at lower and lower prices until they got back to last year’s
prices and the government then bought them. While that’s a completely impractical
way to keep prices from going up, in a market economy the government would only have
to do that with one price, and let market forces adjust all other prices to
reflect relative values. Historically, this type of arrangement has been
applied in what are called “buffer stock” policies, and were mainly done with
agricultural products, whereby the government might set a prices for wheat at
which it will buy or sell. The gold standard is also an example of a buffer
stock policy.

Today’s governments unofficially use
unemployment as their buffer stock policy. The theory is that the price level
in general is a function of the level of unemployment, and the way to control
inflation is through the employment rate. The tradeoff becomes higher
unemployment vs. higher inflation. To say this policy is problematic is a gross
understatement, but no one seems to have any alternative that’s worthy of
debate.

All the problematic inflation I’ve
seen has been caused by rising energy prices, which begins as a relative value story
but soon gets passed through to most everything and turns into an inflation
story. The “pass through” mechanism, the way I see it, comes from government
paying higher prices for what it buys, including indexing government wages to
the CPI (Consumer Price Index), which is how we as a nation have chosen to
define inflation. And every time the government pays more for the same thing,
it is redefining its currency downward.

It is like the parents with the kids
who need to do chores to earn the coupons they need to pay the monthly tax to
their parents. What is the value of those coupons? If the parents pay one
coupon for an hour’s worth of work (and all the work is about equally difficult
and equally “unpleasant”), then one coupon will be worth an hour’s worth of
child labor. And if the children were to exchange coupons with each other,
that’s how they would value them. Now suppose that the parents paid two coupons
for an hour’s worth of work. In that case, each coupon is only worth a half hours’
worth of work. By paying twice as many coupons for the same amount of work, the
parents caused the value of the coupons to drop in half.

But what we have is a government that
doesn’t understand its own monetary operations, so, in America, the seven
deadly innocent frauds rule. Our leaders think they need to tax to get the
dollars to spend, and what they don’t tax they have to borrow from the likes of
China and stick our children with the tab. And they think they have to pay market
prices. So from there the policy becomes one of not letting the economy get too
good, not letting unemployment get too low, or else we risk a sudden
hyperinflation like the Weimar Republic in Germany 100 years or so ago. Sad but
true. So today, we sit with unemployment pushing 20% if you count people who
can’t find full-time work, maybe 1/3 of our productive capacity going idle, and
with a bit of very modest GDP growth - barely enough to keep unemployment from
going up. And no one in Washington thinks it’s unreasonable for the Fed to be
on guard over inflation and ready to hike rates to keep things from overheating
(not that rate hikes do that, but that’s another story).

And what is the mainstream theory
about inflation? It’s called “expectations theory.” For all but a few of us,
inflation is caused entirely by rising inflation expectations. It works this
way: when people think there is going to be inflation, they demand pay increases
and rush out to buy things before the price goes up. And that’s what causes
inflation.

What’s called a “falling output gap,”
which means falling unemployment for all practical purposes, is what causes inflation
expectations to rise. And foreign monopolists hiking oil prices can make inflation
expectations rise, as can people getting scared over budget deficits, or
getting scared by the Fed getting scared. So the job of the Fed regarding inflation
control becomes managing inflation expectations.

That’s why with every Fed speech
there’s a section about how they are working hard to control inflation, and how
important that is. They also believe that the direction of the economy is
dependent on expectations, so they will always forecast “modest growth” or better,
which they believe helps to cause that outcome. And they will never publicly
forecast a collapse, because they believe that that could cause a collapse all
by itself. So for me, our biggest inflation risk now, as in the 1970’s is
energy prices (particularly gasoline). Inflation will come through the cost
side, from a price-setting group of producers, and not from market forces or
excess demand. Strictly speaking, it’s a relative value story and not an
inflation story, at least initially, which then becomes an inflation story as
the higher imported costs work their way through our price structure with
government doing more than its share of paying those higher prices and thereby redefining
its currency downward in the process.

PowerPoint Presentation
Made By Author to Hedge Fund Managers.

Footnotes

1.      I know you’ve got this question on
your mind right now. I answer it a bit later in this book, but let me state the
question and give you a quick answer to tide you over.

Question: If the government doesn’t
tax because it needs the money to spend, why tax at all?

Answer: The federal government taxes
to regulate what economists call “aggregate demand” which is a fancy word for
“spending power.” In short, that means that if the economy is “too hot,” then
raising taxes will cool it down, and if it’s “too cold,” likewise, cutting
taxes will warm it up. Taxes aren’t about getting money to spend, they are
about regulating our spending power to make sure we don’t have too much and
cause inflation, or too little which causes unemployment and recessions.

2.         For those of you who
understand reserve accounting, note that the Fed can’t do what’s called a
reserve drain without doing a reserve add. So what does the Fed do on
settlement day when Treasury balances increase? It does repos - to add the
funds to the banking system that banks then have to buy the Treasury
Securities. Otherwise, the funds wouldn’t be there to buy the Treasury
securities, and the banks would have overdrafts in their reserve accounts. And
what are overdrafts at the Fed? Functionally, an overdraft is a loan from the
government. Ergo, one way or another, the funds used to buy the Treasury
securities come from the government itself. Because the funds to pay taxes or
buy government securities come from government spending, the government is best
thought of as spending first, and then collecting taxes or borrowing later.

3.         Note on how this works
inside the banking system: When you pay taxes by writing a check to the federal
government, they debit your bank’s reserve account at the Federal Reserve Bank
reserves can only come from the Fed; the private sector can’t generate them. If
your bank doesn’t have any, the check you write results in an overdraft in that
bank’s reserve account. An overdraft is a loan from the Fed. So in any case,
the funds to make payments to the federal government can only come from the
federal government.

4.Just a quick reminder that
our state and local governments are users of the U.S. dollar, and not issuers,
like the federal government is. In fact, the U.S. states are in a similar
position as the rest of us: we both need to get funds into our bank accounts
before we write our checks, or those checks will indeed bounce. In the
parent/children analogy, we and the states are in much the same position as the
children, who need to get first before they can give.

Again, if you are
interested in global macro-economics and understanding how monetary policy
affects fiat currencies, which do not behave like a gold backed currency as
explained in Soft
Currency Economics, then sign up to receive a Free weekly Global
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Other Recommended Books

The little book that could ……

Logically,
and in both nominal and real terms, definitively challenge many of the core
held beliefs of the mainstream classical and neo-classical schools of economics

Soft Currency Economics
is
a corner stone publication for the new, widely
popular fresh approach to economics that has come to be called Modern
Monetary Theory (MMT). It explains with actual facts, not theory, and with
non-technical language, the true operational realities of our
monetary system (central banks and private banks). The author, a 40 year
'insider' in monetary operations, and a very successful fixed income hedge
fund manager, wrote this book in 1993 after witnessing the
markets drastically discount sovereign debt on the errant belief
that market forces could force nations into default on debt payable
in their own currency, and that austerity was the only solution.

Randall
Wray, Modern Money
Theory

Randall
Wray, Understanding
Modern Money

William
Black, The
Best way to Rob a bank is to Own One

James K
Galbraith, The Predator
State

About the Author

What others are saying about Warren Mosler:

“One
of the brightest minds in finance.”  CNBC (6/11/10)

“Warren
Mosler is one of the most original and clear-eyed participants in today’s
debates over economic policy.” JAMES GALBRAITH,
FORMER EXECUTIVE DIRECTOR, JOINT ECONOMIC COMMITTEE AND PROFESSOR, THE
UNIVERSITY OF TEXAS – AUSTIN

"In this model of clarity, Warren Mosler debunks (in his
own words) so many of the 'innocent frauds' that have contributed
to our current economic and social malaise. More importantly, Mosler is no
Ivory Tower academic.  He has been a highly successful money
manager, and his characterization of our modern monetary system is spot
on:  Mosler far more accurately depicts market realities than
any of the self-styled "mainstream" economics textbooks, which
dominate in the halls of academe, and in the corridors of power in Washington,
Brussels, and Asia. This book should not only become mandatory reading for students
of economics, but any policy maker who truly wants to deal with the grave
disasters engendered from years of "reading from the wrong playbook"
Marshall Auerback, Director Institute for New
Economic Thinking, Pinetree Capital portfolio strategist, Fellow for the Economists
for Peace and Security, Research Associate, Levy Institute.

“I
can say without hesitation that Warren Mosler has had the most profound impact
on our understanding of modern money and government budgets of anyone I know or
know of, including Nobel Prize winners, Central Bank Directors, Ministers of
Finance and full professors at Ivy League Universities. It is no exaggeration
to say that his ideas concerning economic theory and policy are responsible for
the most exciting new paradigm in economics in the last 30 years - perhaps
longer - and he has inspired more economists to turn their attention to the
real world of economic policy than any other single individual.” DR.
MATTHEW FORSTATER, PROFESSOR OF ECONOMICS, UNIVERSITY OF MISSOURI - KANSAS CITY

“Warren
is one of the rare individuals who understand money and finance and how the
Treasury and the Fed really work. He receives information from industry experts
from all over the world.” WILLIAM K. BLACK, ASSOCIATE
PROFESSOR OF ECONOMICS & LAW, UNIVERSITY OF MISSOURI - KANSAS CITY

-------------------------

Warren
Mosler is a world renowned financier, economist and entrepreneur.  For
Mosler, life has always been about the intellectual challenge of reducing
seemingly complex phenomena to their simplest terms in the chase for the
“elegant solution”.

As
a financier, Mosler is the co-founder of Illinois Income Investors (III), a family
of leveraged fixed income investment funds. He developed numerous successful
strategies that utilized US Government securities, mortgage backed securities,
LIBOR swaps and LIBOR caps, and financial markets in a market neutral, zero
duration strategy. Mosler originated the ‘mortgage swap’ in 1986 and
orchestrated the largest futures delivery to date (over $20 billion notional)
in Japan in 1996. He is also the inventor of a swap futures contract currently
in operation (in a muted form) by a major exchange. III was rated number by MAR
in risk adjusted returns for the prior 10 years in 1997 when he returned
control over to his partners.

Warren
Mosler is currently the Present of Valance Co, Inc. located in St. Croix in the
US Virgin Islands, where he resides. Mosler is also Chairman and majority
shareholder of Consulier Engineering (CSLR), President and founder of Mosler Automotive, which manufactures the MT900 sports car in
Riviera Beach, Florida; Co-Founder and Distinguished Research Associate of The Center for Full Employment And Price Stability at the
University of Missouri in Kansas City; Senior Associate Fellow, Cambridge
Center for Economic and Public Policy, Downing College, Cambridge, UK; and
Associate Fellow, University of Newcastle, Australia.

Mosler Auto